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Homeownership is one of the most straightforward paths to building wealth. The key component of this is growing your equity, which gradually shifts your debt into an asset.
What is home equity?
Home equity is the current market value of your home, minus what you owe. Any gain comes from:
Paying down the principal balance on your loan.
An increase in market value over time.
How does home equity work?
Building home equity is a bit like investing in a long-term instrument, like bonds. Your money is, for the most part, locked up and not spendable.
There are some ways to tap into this equity, but generally wealth is created over years as your share of “free and clear” ownership of the house increases. Building equity is a long financial process, though more immediate market conditions can lead to periods of steep gains or losses.
For example, rapidly rising home prices are contributing to a significant equity increase for homeowners with mortgages across the country. According to data provided by CoreLogic, these homeowners have amassed nearly $3 trillion in equity growth since the second quarter of 2020 — up 29.3% year over year. In September 2021, the median existing home price was $352,800 in September 2021, according to the National Association of Realtors, a 13.3% increase year over year.
In worse markets, plummeting home sale prices have dissolved homeowners’ equity. During the Great Recession, for instance, median sale prices plummeted by over $14,000 from the last quarter of 2008 to the first quarter of 2009.
How do you find out how much equity is in your home?
A home equity calculator can give you an idea of what your home is worth and how much equity you may have if you’re thinking about selling your home or borrowing a chunk of your equity.
Additionally, an appraisal will really nail down the value of your house if you want more specific numbers.
» MORE: How to determine home value
Why is home equity important?
Home equity can be a long-term strategy for building wealth.
Mortgage payments reduce what you owe while your home gains value, so paying on a house has been called “a forced savings account.” This is unlike virtually every other asset purchased with a loan, such as vehicles, which lose value while you pay them off. Your home is also likely to be one of the most valuable assets you will own.
Many homeowners have grown their equity significantly in the past year. At the end of the second quarter of 2020, for example, over a third of U.S. properties with mortgages were considered “equity rich” — meaning the debt on the property was 50% or less of the home’s current market value.
In this same period, only 4.1% of mortgages across the country were significantly underwater, which is when the home’s debt is at least 25% more than its estimated market value.
Home equity takes time to build
Another thing that helps to grow home equity wealth is time. Homeowners who stay in their homes longer are more likely to accrue equity.
In the fourth quarter of 2020, people selling their homes had lived there an average of more than eight years. That was the longest ownership period since the property data provider Attom Data Solutions began tracking homeownership tenure in 2000. Before the recession, people were staying in their homes an average of about four and a quarter years, Attom data shows.
Traditionally, it’s recommended that prospective home buyers follow the “five-year rule.” This is the minimum window of time where homeowners typically will have begun to build enough equity to recoup their initial purchase costs if they decide to sell. If the market happens to cool by the time you choose to sell, you may want to hang tight if possible until the market favors sellers and the value of your home increases.
How you can use your home equity
You don’t have to sell to tap the profit inside your home. Instead, you can borrow against that value with a home equity loan or line of credit. A home equity loan will provide you a lump sum all at once; a HELOC, or home equity line of credit, allows you to draw on the available balance as you wish, similar to a credit card.
If you know how much you need to draw and you plan on using it at once, then a home equity loan may be the right choice for you. On the other hand, if you’re looking for a more flexible arrangement where you can draw cash as you need it, a HELOC could be a better fit.
Using these kinds of loans for expenses that will add to the value of your home, such as completing a remodel or making upgrades, can also increase your equity.
» MORE FOR CANADIAN READERS: What is home equity?