A couple of weeks ago, I wrote about using home equity to plan for investment purchases. I had some questions about growing equity from new investors who haven’t owned property for a long time. I hope the following information helps with a better understanding of equity and how to build it.
Equity is the part of your property that you actually own. It’s the current value of a property less the amount of the liens/loans secured against it. If you own property that’s worth $250,000, and you have a mortgage with a remaining loan balance of $100,000, your equity in the property is $150,000. Investors will often rely to some extent on the equity in their current home or another investment property to help buy their next investment. The more equity you have, the more funds for a down payment on the next investment. So how do you build home equity faster? Especially at the beginning of a mortgage loan, when so little of your payment goes to principal and that equity builds maddeningly slowly.
Naturally, building home equity comes at a price, usually in the form of larger payments. One trap you want to avoid is becoming house-rich and cash-poor. If building home equity means incurring debt to make ends meet, then you’ve defeated the purpose of building equity in the first place.
The first option in home equity building is to make additional principal payments. One way to do this is to sign up for a bi-weekly mortgage, in which you make two payments per month (which added together equal one monthly payment). You will make the equivalent of 13 monthly payments per year instead of 12, which may seem insignificant. But a 30-year loan with a bi-weekly payment plan is usually paid off in about 20 years. You can also apply any other large windfall sums such as a tax return or other surprise/unexpected income to your mortgage balance. Be sure to let your loan service company know that the additional payment is to be applied to the principal only.
The other way to build home equity faster is to refinance. Recently, the reason most people have refinanced is to lock in a lower interest rate and/or lower their monthly payment. The difference in monthly payment between the old payment and new payment should then be applied to your payment. So if your old payment is $2,200 a month and your new payment is $1,900 a month, you continue making the $2,200 monthly payment and $300 goes towards the principal each month for a total of $3,600 annually. This will build equity a little faster than bi-weekly method above.
You can also refinance to shorten the term of your mortgage, which builds equity. If you have a 30-year mortgage at 3.75 percent and replaced it with a 15-year fixed rate loan at 3.25 percent, your monthly payment will increase, but the amount of that payment going to interest will be reduced significantly and the amount paying down the principle will be greater. More of your money is going to build equity, rather than paying interest to the bank. The end result is building more equity in half the time. The down side to this is that a 15-year mortgage is harder to qualify for than a 30-year and it may not be an option.
But what if you can’t afford a higher house payment? Your next best means of building equity is to refinance for less than 30 years. To do so, ask your mortgage company to customize your new loan’s term to match the years that are left on your old loan — if you are five years into a 30-year mortgage, for example, ask for a 25-year loan.
Keep in mind you will not be able to access the entire amount of your equity when getting a second mortgage or a line of credit. Most lenders will typically only allow a maximum of 80% debt on a property when considering a second mortgage or line of credit. So if you have a property valued at $500,000 with remaining loan balance of $300,000, you’ll probably be able to access a maximum of $100,000 of that $200,000 equity because the bank will only allow 80% debt on the property. That still gives you $100,000 to use as a down payment on your next investment property!