What does it mean to build equity? Conventional wisdom says that you should do it, and that one of the main benefits of home ownership is the ability to build equity over time.
What is Equity?
Equity is the amount of the house you truly own. It’s the difference between your loan balance and your home’s market value. If you sold your house and paid off the bank, the value of your equity is what you’d walk away with.
It's also possible to have negative equity. In other words, you owe more than your home is worth.
- For a more detailed discussion, see What is Home Equity?
Equity is an asset. When you build equity, you increase the net value of your asset. One way to do this is by paying off your mortgage. Every month, a portion of your mortgage payment goes towards paying off the loan balance, and another portion of the payment goes towards interest costs. As you pay off the loan, you build equity: you owe a little less, which means you own a little more.
- See how the process works when you pay off a loan: How Amortization Works
Your equity stake can also increase as your home’s value rises. This may happen over time in a favorable market, or it may happen as a result of something you do. For example, if you increase your home’s value by improving the kitchen, you end up with more equity (assuming you didn’t borrow against the home to make improvements).
Sometimes people refer to a mortgage payment as "forced savings." You might not think you're saving any money by making payments each month, but you are building up the value of an asset (like you would build up the value of a savings account by making regular deposits). With a home, the asset isn't cash in a savings account - it's equity in your home.
What can you do with Equity?
You might wonder what you get out of all that equity. The short answer is that it's an asset that you can trade for other assets.
- If you sell your house, you'll get cash for your equity
- If you're buying another house, you can use that money (or the equity) to help fund the purchase of your new house (and therefore you'll borrow less)
- If you ever need cash, you can borrow against the equity in your home with a second mortgage (also known as a "home equity loan")