It’s no secret that real estate can help you build wealth but the surprise is even a small downpayment can get you started. For most, that doesn’t happen quickly or by accident, however. Wealth is a result of leverage applied over time to accumulate equity as you trade up. Your equity then becomes an asset you can borrow against, or “cash out,” to finance other needs, wants and investments throughout your lifetime.
Equity is the ownership interest you have in your home. For example, if your home were worth $400,000 and you had an outstanding loan balance of $300,000, your equity would be $100,000. Equity increases over time as the value of your home rises and you pay off your purchase-money mortgage.
You can borrow against your equity in four ways:
– Refinance your mortgage with cash out
– Get a home equity loan, also called a second mortgage
– Get a home equity line of credit (HELOC)
– Get a home equity conversion mortgage (HECM), also called a reverse mortgage
The Big Secret: Start young
There are many strategies to build equity in your home. One way is to buy your first home when you’re young. The sooner you buy, the more time you’ll have for your equity to grow.
Here’s an example:
Suppose you’re 25 years old. You buy a $200,000 home with a 10% downpayment of $20,000. With a loan amount of $180,000, 4.5% fixed rate and 30-year term, your monthly principal and interest will be $912.
Fast forward 10 years. You’re 35 years old and you’ve made 10 years of mortgage payments. Your loan balance is $144K. If your home appreciated 5% each year, on average, it would be worth just over $325K. If you sold it and paid transaction costs of 10%, your net from the sale would be almost $150K. That’s enough to buy a nearly $600K home with a 20% downpayment and an estimated 5% transaction costs. Don’t want that uptick in monthly payments? Buy a smaller home with maybe a 25% downpayment, and keep growing your equity.
Fast forward another 10 years. You’re 45 years old. Your second home has appreciated in value and you’ve paid off another chunk of your mortgage. It’s time to sell and leverage your equity into a more valuable residence. Each time you trade up, your opportunity to accumulate equity gets bigger, as you leverage equity into each new downpayment.
When to trade up
You don’t have to wait 10 years each time you trade up. You might be ready to move sooner or you might want to keep one of your homes longer. The important point is that if you wait until you’re 45 to buy that first $200,000 home, you lose the opportunity to leverage your equity and build wealth over time. Compare this strategy to renting and the benefit is clear: after 20 years of paying rent, your equity in your apartment is zero.
If at some point you decide to keep your home rather than trade up again, you can pay off your mortgage and own that home free and clear. Your equity would be 100% of your home’s market value.
Your first home doesn’t have to be a shoebox or fixer-upper. It might be smaller than the average in your area. It might be in a location that’s nice, but not within the top school district. The style might be a bit outdated. The goal isn’t to buy your forever home straight out of the gate. It should be to buy smart, sell smart, and build equity over time.
Keep in mind that real estate isn’t a risk-free investment. In fact, housing markets are notoriously cyclical, with booms and busts, especially in volatile, high-priced coastal cities. If you have to sell your home during a downturn, you could lose some or all of your equity.
Owning a home comes with other upsides and downsides. The downsides are ownership costs, such as property tax, homeowner insurance, repair and maintenance expenses. The upsides are the freedom to design a home that fits your needs and a mortgage interest tax deduction, if you itemize. Depending on where you live, if you earn a substantial profit when you sell, you might have to pay a capital gains tax.
You’ll need to earn enough income to qualify for a new mortgage each time you trade up to a more valuable home. You’ll also have to manage your other debt (e.g., student loans, car loans, credit cards) so you’ll be able to afford your monthly house payment. Interest rates fluctuate over time and can affect how quickly you’ll build equity in your homes.
There’s an old saying that no one ever regrets buying real estate, they only regret not buying it sooner.
Learn more about managing the equity in your home as it grows here.