Have you heard that homeownership is key to building wealth? According to the Board of Governors of the Federal Reserve System’s most recent Survey of Consumer Finances, the equity in primary residences accounted for about one-quarter of all assets held by households in 2016, ahead of other financial assets, business interests and retirement accounts. But what does that really mean?
What is home equity?
Home equity is the current value of your home, minus what you owe. So if you own a home worth $300,000 and owe $200,000 on your mortgage, you have home equity of $100,000.
It’s possible for your home to be in a negative equity position if the value of your home decreases faster than you pay off your mortgage. Of course, as a homeowner, you’d likely prefer to have positive equity in your home. Not just for bragging rights, but because it can have a significant impact on the next home you purchase.
How does equity impact my next home purchase?
So what does equity in your current home have to do with the next one you buy? A lot, actually.
Increase purchasing power for your next home
Many first-time homebuyers struggle to come up with a down payment and closing costs on their first home. But after selling that home and paying off the existing mortgage, the excess proceeds can be applied towards the purchase of their next house.
The hope is that after a few years, they build up enough equity to be in a position to afford a house that’s bigger, in a more desirable neighborhood or boasts features they couldn’t afford in their “starter home.”
Several loan programs allow borrowers to buy a home with a low or no down payment. While these loans make homeownership more accessible, they often require the homebuyer to pay for private mortgage insurance (PMI).
PMI is a type of insurance policy that protects your lender if you stop making payments on your mortgage. The cost of PMI varies based on the type of loan you have and your credit score, but typically costs between $30 and $70 per month for every $100,000 borrowed.
However, when you build up enough equity in your home, you may be able to cancel PMI. This can put more money in your pocket each month, and hopefully, help you avoid PMI when you buy your next home. If you are currently paying PMI, you may want to contact your lender to make sure it’s still necessary.
Pull out cash
Have you ever wondered how homeowners manage to sell their existing home while buying the next at the same time? The process can be complicated.
Typically, the investment you have in your home isn’t accessible until after the sale. That can make it difficult to put a down payment on your next home. You can include a contingency clause with your offer on the next house, which means you’ll buy the house only if you can successfully sell your existing home. But in a seller’s market, where several buyers are making offers on the same household, your seller may not be willing to agree to such a contingency.
Fortunately, the equity you have in your existing home can help. You may be able to get a home equity line of credit (HELOC), allowing you to borrow against the investment in your current home. If you qualify for a HELOC, you can use it to access money for your down payment, then pay off the HELOC as soon as your existing home sells.
Increase the value of your existing home
Funding your next down payment isn’t the only potential use for a HELOC. You can also get a home equity loan or HELOC to make improvements to your existing home. Besides making your home more comfortable and attractive, the improvements you make can increase its value, in turn creating more equity.
By tapping your home’s equity to increase its value, you can sell the property and use the new equity you’ve created to pay off the borrowed amount.
It may not feel like you’re earning money when you’re making mortgage payments each month, but you are building the value of an asset: your home. Putting that equity to work makes sense if you can use it to add value to the property or invest in another property. Just think carefully before draining your home’s equity for other reasons. If you run into financial troubles, you’ll have one less source of funds to tap.
For more on this topic, have a look at “How can I tap my equity without selling?”