Building equity means you are making money on your property investment. It builds as the difference between what you owe on the loan and the market value of your home increases. Further, you can borrow against your home for a low-interest rate.
- You need high equity in your home for a variety of reasons
- When you sell your home, you will receive significant proceeds if you treat it as a “forced savings account”
If you maintain your property and diligently pay down your mortgage, you will have access to funds that you can use for a variety of reasons. You must be careful, though, because your house is collateral, and if you can’t pay back such loans you will lose your home.
Building Equity High
High equity is a large, positive difference between what you owe and the market value of your house. There is no set definition for this, but some milestones may help.
- Positive equity means that the value is higher than what you owe
- 20% is a benchmark, and banks usually look for this percentage down payment when you buy a house
- 50% is a psychological number. Most people think more than half is a high percentage
This is important if you want to sell your home. Obviously, you have problems if you owe more than your property is worth. Even if you have a little in your house you have a problem because of the fees associated with the transaction. Therefore, having a high percentage is important.1
20 Equity in Your Home
20 equity means the value of your home is 20% more than what you owe. This is a milestone number for banks.
- Banks require 20% down payment for a conventional mortgage, or you pay private mortgage insurance (PMI)
- FHA and VA loans have lower down payment requirements
The reason banks require this is because property values fluctuate. If the market value goes down, they can still recoup their money if they need to foreclose. You should always save for this down payment when you buy your house. Further, if you put a large payment down on your house you will save on interest over the long run, and you know that you have 20% from the beginning.
How Do I Know if I Have 20% Equity?
You know you have 20% equity when the market value is 20% higher than what you owe.
- Check your bank statement. It tells you your outstanding balance.
- Check realtor.com or with a local agent to find out how much homes in your area sell for.
If you have a conventional mortgage and the bank does not require you to pay PMI, then you have this much money in your home. If home values in your area are 20% higher than what you owe, then you are above this threshold, too.
Let’s look at a couple of examples. You check and see that similar houses in your area sell for $200,000 recently. Your bank statement says you owe $100,000. In this case, you have 50%. If houses in your area sell for $200,000 and you owe $150,000 then you have 25%.
Building Equity in the Lot
Lot equity is the underlying value of the land without any structures (like a house). You can also think of it as land equity. Usually, developers care about this when they build houses. It’s part of their expenses on new construction. However, it’s not bad for homeowners to think about this, too.
- The land your house is built on has value, regardless of improvements (like your house)
- The land has more value in some areas (like NYC) than others (like west Texas)
- Supply and demand dictate that land values are somewhat stable
- Structures depreciate
- Maintenance has a huge impact on the value of the structures on a property
You should think about the value of the land your house is built on. It reflects how strong the market is in your area. It is a gauge of how much people want to live in your neighborhood. We think of the structures as depreciating assets, but the land is not. You can increase the value of your property by renovating, adding, improving the esthetics (like landscaping), but you cannot do anything to change the value of the land that your house is built on.
Equity When You Sell
Building equity is important when you sell. The proceeds go toward transaction costs and then to you. A title company or escrow company (depending on where you live) holds the funds until closing. They then distribute checks to the people involved in the sale. If any money is left it goes to you, the seller. These can be broken down into three categories:
- Commissions are the biggest expense a seller has at closing, usually 5%-6%
- Closing costs, such as title insurance and recording fees, usually 1%-3%
- Homeowners usually pay property taxes in arrears, or for the previous time period, sometimes quarterly, semi-annually or annually
Real estate transactions are expensive for both the buyer and the seller. Sellers’ fees can be as high as 10%. You can sell your home for more than it is worth and still must write a substantial check at closing.
Here is an example. You owe $188,000 on a house that you sell for $200,000. You pay a 5% commission, $10,000. Your closing costs run $2,000. You have taxes of $1,000.
You still must write a check for $1,000 to close your house, even though you sold it for $12,000 more than you owe. In this example, your closing costs, as a seller, are 6.5%. This is typical for a property transaction.2
Buying a House With Equity
Building equity, again, is important because when you buy a house you can use the proceeds from selling your old home as a down payment for the purchase of your new one. Make sure that you understand the numbers before you do this because fees for both selling and buying a house are substantial.
- Buyers’ closing costs usually run 2%-5%
- Sellers’ closing costs typically run 8%-10%
As you can see, once you factor in a down payment you need quite a bit of money to sell one house and buy another. For most people most, and often all, of the proceeds from the sale of one house go to the purchase of a new one.
Another example may be helpful. Your family grows with a new baby, and you want a bigger house. The house you sell your old home for $200,000. The house you want to buy is $300,000. In order to put 20% down on your new property, you set aside about $95,000. This includes $20,000 (10%) for closing costs on your old house, $15,000 (5%) on your new house, and $60,000 down payment on the property you purchase.
As you can see, you need almost 50%. Therefore, you should not borrow against your home unless you have a very good reason.3
Equity Towards Down Payment
Building equity in your current house helps when you buy a new property because you can count it toward the down payment on your new home. In fact, in most cases, banks encourage it. There are two ways to use the money from your sale in your purchase.
- Link the contracts – both transactions happen at the same time
- Use a bridge loan – if your purchase happens before your sale
Both are common. Banks especially like to use proceeds from the sale of a home as down payment because the money is not liquid. This means you cannot easily tap into and spend it frivolously.
Difference Between Building Equity and Down Payment
Building equity is storing the value in your house, while the down payment is the amount of money you put into the purchase. These two will be equal only at the time of closing.
Should I Build Equity to Buy Another House?
Whether you should use equity to buy another house depends on your situation and the type of property you want to purchase.
- Are you moving to a new home?
- Are you buying a second home or vacation house?
- Do you want an investment property?
When you are moving it is very logical to take the proceeds from the sale and put it down on your new home.
When you buy another property things are more complicated. We recommend saving and then putting money down, but many people refinance to get cash or take out a home equity loan for this purpose. Taking on more debt always carries risks.
You expect to get a return on investment properties. Either you will renovate and sell in a short period of time, or you expect to have a steady income from the property. In either case, you are taking investment risk. While we recommend that you don’t use your home’s equity, market timing often necessitates this. Just remember that if the investment goes bad you may lose the roof over your head.
Can I Keep the Money from Selling My House?
You can keep the money from selling your house. There is a caveat to this, though. Whenever you sell your home there will be closing costs. We discussed them earlier, and they can commonly go as high as 10%. Always factor in those fees while you calculate how much money you will get from the sale.