Have you recently started the process to become a first-time homeowner? When you go through the different stages of buying a home, there can be a lot to know and understand. For example, when you purchase property, you don’t fully own it until you can pay off your mortgage.
Home equity is how much of the property you actually own, and it can be a great asset in the long term. So what is equity in a house, and how do you calculate home equity? Below you will find everything that you need to know.
What Is Home Equity?
Many people need to take out some type of loan to help purchase their first home. Or, if they have already purchased a home, they might take out a second mortgage at a later date. This means that they only own a certain portion of the property.
Even though you are technically the homeowner, you will not fully own it until you pay off your mortgage or repay the purchase loan. Home equity is the current value of your home minus any amounts that you owe or other liens against it, if there are any.
How to Calculate Home Equity
The value of your home minus any outstanding loans you have is home equity.
Let’s say that you purchase your dream home at a market value of $400,000, and you decide to make a 20% down payment, which reduces the total from $400,000 to $320,000. You then take out a mortgage loan to cover the rest of the balance and pay it off over time.
Since you contributed $80,000 of the purchase price, it means that you only own $80,000 worth of your home, or 20% equity. Ultimately, this is how to calculate home equity.
Now, for this example, let’s assume that the housing market significantly increases and the total value of your home doubles, making it worth $800,000. When this happens, your loan balance will remain the same, yet your home equity will increase.
To calculate your new home equity percentage with the increase in market value, you divide the original loan balance by the new market value. Then, you subtract that result from 1 and convert the final decimal into a percentage. It would look like this:
$320,000 / $800,000 = 0.4
1 – 0.4 = 0.6 = 60%
Therefore, you would now have a 60% equity stake in your home, which is a 40% increase from your original down payment. This is why home equity can be an excellent asset for you as a homeowner, even if you don’t own 100% of it.
Why Is It Important?
Home equity can be important if you sell your home and want to make a profit. It’s considered an asset, and it will count towards your overall net worth. Plus, home equity can get cashed out through loan financing or be used as collateral if you want to take out a home equity line of credit.
A home equity line of credit is a particular type of loan that ends up getting secured against your home. This can help reduce your interest rates to a much lower level. You can even use your home equity to help fund property renovations or purchase a second home.
Is it Possible to Have Negative Home Equity?
The simple answer is yes, you can have negative home equity. This typically happens when your loan amount is higher than the market value of your home, which might be the result of having a small down payment. But there can also be a few other factors.
Sometime’s it might be due to lenient lending requirements or if there is a big change in the housing market. For example, if you purchase a home while the market is at its peak, but then it dramatically declines, it can cause negative home equity.
It can also happen if you take out a high-interest loan that doesn’t require large enough amounts to get paid towards the principal.
If any of these situations happen, it can put you in a tough situation as a homeowner. But, you can sell and pay off the negative equity or rent the property to help get back on track. You can also create a plan to make the right amount of payments to help reverse the negative equity.
Tips for Increasing Your Home Equity
Your home equity can increase if the housing market rises, but when and how that happens is entirely out of your control. The good news is that there can be a few different things you can do to help increase it on your own. The first way is by paying off your loan balances as efficiently as possible.
For example, most home loans are known as standard amortizing loans. These typically have equal monthly payments that you make, and the amount you pay reduces your principal and your interest rate. In this case, the amount that you pay back towards your principal repayment will increase over time.
This contributes to building equity at a faster rate year after year. You can also increase your home equity by increasing the value of your home. This can do this by making various home improvements, for example. Home’s that are well cared for will be more desirable than ones that aren’t.
Another tip that you can explore is using accelerated mortgage payments. Usually, most homeowners will make their mortgage payments every month, with a total of 12 payments every year. But, if you split this up and make a payment every two weeks, it can help reduce the interest you pay.
This helps pay off your total mortgage in a much shorter amount of time, ultimately increasing your home equity. That said, it’s important to confirm with your lender whether or not you can make bi-weekly payments. It might depend on the rules they have in place.
