I’m going to let you in on a little secret: one of the best ways to build wealth is through the purchase of your personal home and investment properties. This might not actually be a secret, but I wanted you to know anyway. Why is this such a good way to build wealth? It’s because of something called home equity. Home equity can help you build wealth over time, and it opens up opportunities to leverage that equity to accomplish goals in the future, like purchasing investment homes paid off with other people's money in the form of rent. There’s a lot to unpack in that sentence, so let’s start by breaking down the ins and outs of home equity and how you can use it to help expand your financial position.
Understanding home equity can be confusing, so here are three simple ways to define this important part of homeownership. Home Equity is a property's market value or appraised value minus any claims or liens against it. In other words, Home Equity is the percentage of a property that you actually own. It is the financial interest you have in a property.
Now that you know what home equity is, let’s figure out how much home equity you may have in your primary residence or investment properties. In its most simple form, imagine that you negotiated a purchase price of $450,000 for your primary home. You put up $50,000 as a down payment. To get the keys to the house, you still need to give the seller $400,000, which you obtain as a loan from a mortgage lender. To calculate your home equity position, divide your home's worth ($450,000) by your down payment ($50,000). You get 11%. That means you have 11% equity in your property on the day you took possession of your primary home. The lender holds the remaining 89% because it has $400,000 invested in the property.
Home equity can be built over time in a few different ways, but you must meet certain qualifications. First, you must make it a habit to pay every mortgage payment on time. Second, you must choose the right mortgage type. I mean avoiding an interest-only loan, where no principal is paid off until a single lump sum is paid. If you do both, you can build equity consistently. That’s because as you repay your mortgage loan, you're also gradually building equity in your home. Every time you make your monthly payment, a large chunk goes to paying down the interest on the amount borrowed, and a small portion goes towards paying down the loan's balance — also known as the principal. As your loan balance decreases, your equity in your home increases.
My goodness, you're saying to yourself. That’s gonna take forever. Just remember that slow and steady wins the race. Ask me how I know in the comments below. But if you are not the patient type, here are a few ways to build equity a little faster. First, when you make your monthly mortgage payment, include a second check for some amount and have it applied to the principal. Second, your home equity position can also increase if you take on a home improvement project. For example, imagine you borrow $20,000 from your home equity to update the kitchen, increasing the property value by $35,000. That renovation just boosted your home equity by $15,000. But make sure to do your research beforehand because not all improvements will boost your home’s value. Third, choose your home’s location wisely because equity increases if your home’s value increases. That may be due to improvements made to your local economy, like opening a new manufacturing facility or technology park or revitalizing a downtown shopping district. Or living at the beach like I do. You can benefit just by having a home in a desirable neighborhood. Ask me how I know in the comments below.
Now that you are building home equity let’s fast forward a couple of decades and discover how home equity can help your family. Even though it's tied up in your home, equity is considered a part of your net worth. It's an asset that you can tap into when you have a larger-than-normal expense that you need to meet. I’ve already mentioned that you could borrow against your home equity to make home improvements. You also can borrow against it to purchase a second home, buy a new car, pay for a wedding, pay off student loans, or cover college tuition for your kids. Or you could leave it where it is and watch it grow. It's up to you.
If you decide to leverage the equity you have built up in your home, you have several choices. Each is based on the total equity built up so far, your credit score, and your history of making monthly payments. That last condition is the key. One choice is a Cash-Out Refinance. This involves using your equity to get a new mortgage that’s larger than the amount owed on your existing mortgage. After you pay off your existing mortgage, you can then use the remaining money however you choose. Basically, this allows qualified borrowers to borrow some of their home’s equity and refinance their home loan at the same time. Just make sure that the current interest rate is lower than the rate applied to your original mortgage.
A second way to leverage your home’s equity is a Home Equity Line of Credit. Also known as a HELOC, this is a revolving credit line with an adjustable interest rate. Qualified borrowers can borrow up to a certain amount over a period of time. Think of it like your credit card: you can continually borrow money up to an approved limit, but you also need to pay off the balance as you go.
A third option is a Home Equity Loan: Qualified homeowners can use a home equity loan (also known as a second mortgage) to borrow a lump sum against their current home equity for a fixed rate. The loan must then be paid back within a term agreed to by the lender. What's nice about a home equity loan is that you get fixed, predictable interest payments over the length of the loan. Whichever option you choose, keep in mind that most lenders won't let you borrow against the total amount of your home equity. Typically, borrowers with perfect payment histories and good credit scores can borrow up to as much as 80% of the homeowner's available equity.
Homeownership is something to be proud of! Take pride in your home and your home equity. Home equity is a powerful tool that can help you achieve your goals or be there when some tsunami hardship hits your family. I wouldn’t be recording this video if I didn’t have the home equity for First Citizens Bank to tap into and loan me the money to improve both my personal and business financial positions. Thank you, Danielle Long, my banker at the First Citizens branch in Swansboro, NC. If you have a thought, leave it in the comments below. If you learned something, please subscribe to Emerald Isle Vacation Home Specialist. It’s free. Thanks so much for reading!
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