When you speak to a real estate agent about buying a home versus renting, they will often give you a spiel about “building equity.” While that is a good line of thinking--the actual meaning is often lost on first-time buyers. So let me explain:
Equity is the difference between the market value of your home and the amount you owe on your mortgage.
For example: if you were able to sell your home for $200,000 and you owe $150,000 on the mortgage, then your equity is $50,000. This is very simplified because it doesn’t take into account the actual cost of selling your home, which can be quite substantial. If it costs you $15,000 to sell that home (real estate commissions and closing costs), your net equity is reduced to $35,000. In short, net equity is the amount you would actually pocket at the end of the sale.
How do you build equity?
For starters, the more money you have for a down payment on a home, the more immediate equity you will be able to build through ownership. If you buy a home with cash, for instance, you have no mortgage and thus no differential between value and money-owed to a lender. Every penny of equity that comes of owning the home goes back to you fully. The larger your initial down payment, the more your equity builds.
Homeowners can build home equity in a variety of ways, but the three most common are as follows:
The fair market value of your home can increase because similar houses in your area are now selling for more. You may have bought your home two years ago for $100,000 but if you sold it today it would be worth $120,000 because the market has increased. Your equity in the home has increased by $20,000 due to this increase. In general, housing markets increase in value over time, so the longer you own your home, the more equity you will have, not withstanding a substantial economic downturn that effects home values.
If you make home improvements that correspond to a higher anticipated sales price for the home, you may be increasing your equity as well. For example, you might spend $10,000 on remodeling your kitchen and this increases the market value of the home by $30,000. Now you've increased your equity by $20,000. Not all home improvements result in an increase in equity, though. Some routine improvements like fixing a leak or replacing a hot water heater will cost you money but may not increase the overall value of your home.
With every single payment you make on your mortgage, you build equity. Why? Because each payment chips away at the principal balance you owe on the loan. As the loan balance decreases, your equity increases. Making extra payments toward the principal increases your equity even more quickly.
Can equity decrease over time?
Yes, but not usually. If the housing market crashes (like it did 2006-2011), home values will fall, decreasing your equity. You may also experience a drastic decrease in equity if you if you take out a second mortgage or home equity loan without proper foresight. And there is always the chance that an accident will adversely affect you. If your home burns down or is damaged in a disaster and you don't have enough insurance to pay for your loss, then you will lose equity if you need to repair or rebuild out-of-pocket.