The Importance of Home Equity in Building Wealth
Purchasing real estate is one of the most reliable paths toward building personal wealth, especially in Middle Tennessee, where home values are consistently increasing. However, the amount of your home’s value that should be included in your assessment of your net worth is called equity, and it is our topic today. Whether you’re shopping for your first property, wondering whether equity can help you improve your current home, or are curious whether paying off more of your home loan now is the fastest way to beef up your wealth, we’re here to help.
Q: What is equity, and how is calculated?
A: Simply put, equity is the dollar amount assigned to the percentage of your home that you independently own.
For simplicity’s sake, let’s use unrealistic numbers and say one has taken out a home loan for $300,000.00. At the outset, provided the owner purchased the home with 0% down and an interest rate of 0%, their equity would be 0%. However, after 5 years, we may expect that they have paid $150,000.00 toward their loan, which would result in their having 50% equity at that point.
Equity is what you possess minus what you owe.
Q: Is equity set in stone?
A: Only as far as your home’s value remains exactly steady. Now, since this never happens in the real world, let’s discuss the effect of fluctuating values on your equity valuation.
When your home’s value increases or decreases, so does your equity. Although the percentage of your home that you own remains the same, this percentage will be worth varying dollar amounts over time.
The good news is, despite temporary dips in the market, the overall arc of real estate has risen consistently over the past several decades. If you purchase a home that becomes worth less than you paid at some point in the future, you will be able to avoid negative financial repercussions as long as you are in a position to retain ownership and wait for the market to recover.
Q: What is “sweat equity?”
A: Rather than resulting from financial contributions, sweat equity is a term homeowners use when they have increased their property’s value through home improvements and remodeling. When you hear people talk about “flipping” a home, they are describing a rapid, DIY approach to maximizing the dollar amount of their equity.
Q: How will increasing my home equity add to my available wealth?
A: There is a somewhat common misconception that equity is only helpful if a homeowner wants to sell during a peak in the market. The reality is that selling a home is not the only way to benefit from equity. Instead, home equity is an excellent resource that can be drawn on to catapult a homeowner toward increased personal wealth.
- Banks are eager to work with property owners who can demonstrate a robust equity value.
- When you are ready to move into a larger, more luxurious, or more ideally situated home, you can invest your existing equity into a new property, even without saving up for a new down payment.
- If you should experience a period of time wherein you struggle financially or wish to retire early, you will be able to take out a reverse mortgage, or home equity loan, and sell your equity back to your bank over time.
- A home equity line of credit, or HELOC, is the least structured means of accessing your equity. Unlike home equity loans, HELOCs carry variable interest rates, and may not grant you immediate access to funds. Instead, a HELOC works like a traditional credit card, and have 1) a draw period, often 10 years, and 2) a repayment period, often 20 years.
HELOCs are commonly used to fund home improvements that are spaced out over a long period of time, continuing higher education, or establishing an independent small business.
- A cash-out refinance is a way for you to access additional funds without taking out any kind of loan. Instead, you will be refinancing your home for a higher amount, which will permit you to withdraw the difference. This immediate influx of liquid assets may be ideal for you, but please be aware that your closing costs will likely be quite high, and banks may be reluctant to work with you once they have seen your willingness to tank your own equity.
Whether or not it is fair or accurate in your case, banks may believe that you are withdrawing funds because of wealth mismanagement, or a decline in your life circumstances.
Please note: home equity loans and home equity lines of credit are not suitable means of funding consumer or recreational spending. In order to contribute to your wealth, your equity should always be invested into executing your long-term financial plan.
Q: How should I use my home’s equity to build my wealth?
A: The ideal strategy for your situation depends on your credit score, overall financial situation, and your proposed use for your money. After reviewing the recommended courses for each situation outlined above, we recommend consulting with your financial institutions before making any decisions.
Consider your long-term situation as much as you can and weigh how prepared you would be in case of financial hardship. Are you prepared to support yourself if your income stops for a full year—or more? Are you on track for a timely retirement? Will you be able to support your children in their educational goals?
Regardless of your situation, investing in home equity is an excellent way to ensure your wealth increases in both the short and the long term.
If you are currently shopping for a home in Middle Tennessee, please contact Legacy Home Loans today!