How to build equity in your home (and why you should)

If you’re a homeowner, the mortgage payments you’re making every month can help you build a powerful asset: home equity. Home equity represents the amount of your home that you own free and clear, as opposed to the amount you financed (and still owe). As you pay down your mortgage, the amount of equity you have in your home grows over time, allowing your home to become a more valuable asset, and your net worth to increase.

Of course, you can always wait to cash in the equity when you sell the home. While you still reside in the place, though, home equity can be tapped to pay for major expenses: remodeling, college tuition or other financial needs.

For all these reasons, increasing home equity is an important part of homeownership. Here’s how to build equity in your home — before you buy it and as you live in it.

What is home equity?

Home equity is the portion of your home that you own outright. If your mortgage is paid off or you bought your home all in cash, you have a 100 percent equity stake in your home. Otherwise, your home equity is calculated by subtracting your mortgage balance from the home’s current market value. Say your home is worth $350,000 and you owe $150,000 on your mortgage. To determine your home equity, you would use the following calculation:

If you’re looking to take out a home equity loan or home equity line of credit (HELOC), it’s good to know how much equity you have because lenders set borrowing amounts based on that equity. Generally, the more equity you have, the more money you can borrow. Knowing how to build equity in a home helps you create a valuable asset over time, and appreciates your overall net worth.

Why building equity in your home is important

Building home equity is important for a few reasons. It can not only be a reliable way to create wealth but can also help you maintain the home while you’re living in it.

Building equity in a property means:

• You can use home equity for nearly any purpose. Homeowners can borrow against the value of their homes through home equity loans and HELOCs. With a home equity loan, you receive all funds at once and immediately start paying the loan back over a period of up to 30 years. When you take out a line of credit or HELOC, you have a draw period (often five to 10 years) when you can withdraw the cash you need when you need it and make interest-only payments. You then have a repayment period (typically 10 to 20 years) during which you pay back both interest and principal.
• You are more likely to make a profit when you sell the home, even if you still have an outstanding loan balance. Building equity means you have a much better chance of selling the property for more than you owe on the mortgage, even if the market takes a (down) turn. You can use the profits from the sale to purchase another home or pay off other debt or invest it elsewhere.
• You can build long-term wealth. Building home equity can help you increase your net worth over time, especially if you purchased your home when the market was in the buyers’ favor. A home is one of the few types of collateral that has the potential to appreciate in value (cars, for example, depreciate over time). It also can furnish a source of wealth for your descendants.

How to build equity in your home

There are a variety of ways to build equity in your home more quickly. The process generally involves increasing your property’s value or decreasing your mortgage debt, or some combination of both. Below are a few options available to homeowners.

1. Make a big down payment

Building equity starts the moment you fork over your down payment. Remember: Home equity equals the amount of your home you own outright, and you own outright what you actually pay out of pocket for (as opposed to financing with a loan). So, the more cash you contribute towards the home purchase, the bigger your ownership stake.

While it may be possible to buy a house with as little as 3 percent or even zero percent down, a larger down payment instantly boosts your home equity. The percentage of the house you finance, you don’t own — the bank does.

When figuring your down payment though, consider how much savings you’ll have remaining after closing. Leaving yourself with little to no cash reserves makes it harder to handle any financial emergencies that arise and can even make it more challenging to cover your regular monthly mortgage payment. You’ll also need to account for home maintenance costs, which typically run about 1 percent of the home’s value in the first year.

2. Avoid mortgage insurance

If you can put down at least 20 percent on the home purchase, you’ll also avoid having to pay private mortgage insurance (PMI) each month. It’s an additional surcharge built into your mortgage payment — a burden you don’t need. Avoiding having PMI (or MIP if it’s a government-backed loan) added to your mortgage payment can free up funds each month and can help grow your home equity.

3. Pay closing costs out of pocket

When you take out a mortgage, you may get an offer from your lender to roll any closing costs into your mortgage. Admittedly, it’s tempting, as these can often add up to a few thousands (as much as 5 percent of your loan). But, doing so adds to the monthly amount (the loan principal and the interest) you pay.

Paying closing costs and other upfront fees right away, if you can afford it, is a more economic move. It will help boost your equity because it means more of your dollars are going toward the principal, and it keeps the principal (and the amount of interest charged on it) smaller. This strategy applies to a mortgage, but it can also apply when you take out a refinance loan, which also incurs closing costs and fees.

4. Increase the property value

Making improvements to your home can boost its value and, therefore, your equity. Just keep in mind that you likely won’t recoup all the money you put into home projects. Some projects offer a better return on investment than others.

For example, according to Remodeling’s 2023 Cost vs. Value report, the average upscale bathroom remodel provides a 66.7 percent return on investment, and the average minor kitchen remodel provides a 85.7 percent return on investment. The project that offers the greatest bang for the renovation buck is converting your HVAC system from a fossil-fuel-based one to an electric one, which provides a 103.5 percent return.

Before taking on your next remodel, be sure to research first, or consult with a real estate agent or another home professional to get a sense of what improvements provide the most return. The goal is to avoid putting too much money into renovations that offer little to no increase in your home’s value. An expert can help you sort through the options and select projects and even details — finishes, features, appliances — that provide the most reliable payoff for your efforts. Sometimes, less is more: While the minor kitchen remodel offers a 85.7 percent return on investment, a major remodel offers only 41.8 percent.

5. Pay more on your mortgage

Most mortgages are on an amortization schedule, meaning you make payments in installments over a set period of time until the loan is paid off. As you pay down the mortgage, your equity stake increases. While you’ll always pay both principal and interest, a larger portion of the payment goes toward interest initially, and then more goes toward the principal over time.

However, if you make extra payments toward the principal every month, you build home equity quicker by decreasing the overall total owed on the debt. If you have the means to pay a little extra, call your loan servicer and ask how to do it. Check your monthly statements to make sure the extra money goes toward the principal.

Here are a few ways to pay your mortgage off faster:

• Switch to biweekly mortgage payments. Split your mortgage payment in half and send each half every two weeks instead of once at the end of the month. This adds one extra payment to your mortgage every year, which can ultimately shorten your loan term and save you money on interest.
• Add a certain amount each month. Check your budget to see how much extra you can realistically put toward your mortgage every month. For example, if you just paid off your car loan, consider putting that extra $250 toward the mortgage every month.
• Use windfall funds. Any time you receive a tax refund, a bonus at work, or a cash gift, put it toward your mortgage balance.

When paying down your mortgage more aggressively, be sure you’re not leaving yourself strapped for cash each month and running up credit card balances to make ends meet. And while reducing debt is never a bad thing, making your money work for you — i.e, investing — is important too. So, don’t neglect proactive wealth-building efforts, like funding an IRA or 401(k) plan account.

6. Refinance to a shorter loan term

A shorter loan term has two main benefits: You typically get a lower interest rate, and more of your mortgage payment goes toward the principal each month. Choosing a 15-year mortgage from the start helps you build more equity every month than you would with a 30-year mortgage, because you’re paying down the debt faster. If you already have a mortgage, you can refinance into a shorter-term loan.

However, there’s a catch: Payments are higher on a shorter loan. Make sure there’s room in your budget for that larger mortgage payment before you opt for the shorter term loan or refinance to one.

Also, because of their larger payments, shorter loans may be a tad tougher to get. To qualify, you’ll need a bigger income, higher credit score and lower debt-to-income ratio than you generally would with the traditional 30-year mortgage.

7. Wait for your home value to rise

Local housing markets change over time, so your home’s value might fluctuate. When home prices increase in your neighborhood and demand grows, the value of your home rises.

Conversely, when home prices drop, you might lose some equity. To help protect yourself from this type of market shift, it’s a good idea to avoid borrowing too much equity from your home. When you do withdraw equity, using the money to make valuable home improvements can also help protect your property’s value. While you don’t have much control over real estate market fluctuations, it’s good to keep this factor in mind. You can check your home’s value using an online home price calculator or by consulting a professional appraiser.

8. Avoid a cash-out refi

If you’re refinancing your mortgage, avoid the cash-out refinance if you can. In a cash-out refi, you’re replacing your old mortgage with a bigger one; the extra money you receive outright in cash (hence the name). This amount is based on the value of the equity you currently have in the home.

Basically, you’re borrowing against your ownership stake — which essentially reduces it. You’re taking equity out of the house, in other words. Not good if your goal is to increase it.

A cash-out refi can be useful. But in this case, it’s counterproductive. Stick to a rate-and-term refinance, which will potentially allow you to reap the rewards of a lower interest rate or a shorter-term mortgage while keeping your ownership stake intact.

How home values will impact home equity in 2024

Obviously, home equity goes hand in hand with property values in general. During the height of the pandemic, home prices skyrocketed for a combination of reasons: lack of available inventory, record low interest rates and intense buyer demand. That trifecta sent the value of homeowners’ equity stakes soaring.

However, the real estate landscape is significantly different in a post-pandemic world. In many places around the country, the housing market has been slowing down or cooling considerably thanks to the steep mortgage interest rate environment. As a result, there were fewer homes on the market in 2023 and fewer sales.

Mortgage interest rates are expected to drop slightly in 2024 and home sales are likely to pick up a bit, but not significantly. That’s largely because mortgage rates are expected to remain above 6 percent in the coming year.

It’s also likely that there will be slightly more inventory on the market during the year ahead. But again, don’t expect a dramatic uptick in the amount of housing available for sale. Many existing homeowners will still be unwilling to put their homes on the market and lose the low interest rates they locked in in days of yore to buy a new place.

So what do these market dynamics mean for home equity? It’s not likely that values will decline substantially given the tight inventory. That reality will keep home prices relatively high, along with homeowners’ ownership stakes. Although the rapid-rise days are over, appreciation will still happen. CoreLogic’s “Home Prices Insights” report forecasts that prices will increase on a year-over-year basis by 4.5 percent between May 2023 to May 2024. That is good news for the creation of equity.

Bottom line on building home equity

Building equity takes some time, but it’s worth it. Making a sizable down payment, boosting your property’s value via improvements and paying more toward your mortgage monthly are just a few ways to increase your ownership stake.