Owning a home comes with a number of obvious perks.
For starters, you'll own your own property — a valuable asset that you can carry to the future. You'll also have a lot more freedom and flexibility, and you'll be able to take advantage of some tax breaks when it comes time to file your taxes.
READ: 7 Things You Need To Know About Home Equity Lines Of Credit
More importantly, you'll have the opportunity to build substantial equity in your home. This can help provide you with wealth and financial security as you continue to pay your mortgage. It also means that there's a lot of money sitting in your home that you could use for other purposes.
Here's what you need to know about home equity.
What is 'Equity'?
Home equity is essentially the value of your home, minus what you still owe on your mortgage. That amount is what you actually own.
For instance, let's say your home is currently valued at $700,000, and you still have an outstanding balance on your mortgage of $300,000. That means you have an equity of $400,000 ($700,000 - $300,000).
While you may be on the title of the property and "own" it, you technically only own about 57 per cent of the property in the above example. If your home increases in value in two years to $900,000 and you contribute another $25,000 towards the principal portion of the mortgage, you would now have about 69 per cent equity in the home.
Even though the lender doesn't own the home, the property is securing the mortgage and being used as collateral. As such, the lender could repossess it if you ever default on your mortgage.
This is a simplified example, as there may be more complicated situations where there are second mortgages and liens on the property that would also have to be factored into the calculation.
READ: 7 Questions Buyers Should Ask Their Mortgage Lenders
How Do You Build Equity in Your Home?
There are basically two ways that equity in a home is built:
Paying down the principal portion of the mortgage
Every mortgage payment you make will go towards both the principal and interest portions. The principal portion is what goes towards building the equity of the home. As such, as you make mortgage payments every billing cycle, your home's equity increases.
Increasing its market value over time
Over time, property values increase. Even if there are dips in the real estate market every so often, the value of properties will increase eventually as time progresses. That means your home will gain in value - and therefore your equity will increase - even without making mortgage payments.
You can also speed up this process by making improvements to your home. Certain upgrades can immediately increase the value of a home, such as kitchen upgrades, bathroom remodels, and floor replacement.
Why is Equity So Important?
Home equity is important because it can be used as a long-term wealth-building strategy. With every mortgage payment made, the property increases in value while simultaneously decreasing what is owed.
Having a home and a mortgage basically forces you to build a type of savings account. Each time a mortgage payment is made, you put more savings into the pot. Home equity is a unique type of asset in this way.
All other types of loans may force you to make payments, but the asset in question does not appreciate in value. Rather, it decreases in value, as is the case with a vehicle or furniture, which depreciate as their respective loans are paid off.
With home equity, you have something of significant value that can be used at some point to cover major expenses.
What Can You Use Your Home's Equity For?
You own your home's equity, so you can use it as a financial tool in a number of ways:
Borrow against it.
There are specific loan options available that allow you to tap into your home equity to be used to cover other expenses. A home equity loan will provide you with a lump sum of money that can be used to pay for a home renovation project, college tuition, a medical emergency, or any other expense that needs to be covered.
There is also a HELOC loan - or home equity line of credit - that allows you to access revolving credit against your home's equity and can be used in much the same way as a credit card. You can borrow as much or as little against the credit limit you're given any time the need arises. As you repay what you've withdrawn, you can continue to make withdrawals.
Take out a reverse mortgage.
Homeowners who are at least 55 years of age may be able to access as much as 55 per cent of their home equity to be taken out as cash, tax-free. A reverse mortgage is a type of loan that's secured against a home's value.
The money obtained through a reverse mortgage can be used for any number of expenses while maintaining ownership of the home, with no monthly mortgage payments needed. The loan must be repaid, however, if you move or sell. You must maintain their property and continue to pay taxes and insurance.
Use the proceeds towards the purchase of a new home.
If you decide to move in the future, you can use the equity built up in your current home to be put towards the purchase of a new property. Even if you still owe money on your mortgage, you can still use your equity.
Final Thoughts
Having equity in a home can afford you with a lot of opportunities and financial security. With every passing day and every mortgage payment you make, your equity will continue to build. This will leave you with something of significant value that you can use for a variety of purposes, or simply as a financial nest egg to cushion you now and into the future.
