For some homeowners, their house is a place of comfort and security. For others, it also represents a potential path to financial stability. Home equity, the portion of your home you own outright, can be a powerful investment and wealth-building tool. However, using equity to build wealth can also be extremely risky.
This article weighs the risks and potential rewards of leveraging equity for financial growth. We cover the ins and outs of home equity, highlight several investment opportunities available to homeowners, and provide an unbiased outlook on the pros and cons of equity-led investment strategies.
What is Home Equity?
Equity is the difference between your home’s value and the amount you owe on your mortgage, known otherwise as the percentage of your home that you own. For example, if your house is worth $600,000 and you owe $400,000 on your mortgage, you have $200,000 or 33% in home equity.
When you first purchase a property, your home's equity will likely be minimal, especially if you made a small down payment. However, you’ll build equity over time as you make monthly mortgage payments or the value of your home increases.
How to Build Home Equity
No matter how you go about it, building home equity takes patience. It’s typically a gradual process with significant increases developing over time, but there are a few opportunities you can leverage to accelerate this growth:
- Make extra mortgage payments: Homeowners who put extra funds toward their mortgage principal can reduce their loan balance and build equity faster. Even small, regular payments can have a positive impact.
- Choose a loan with a shorter term: Homeowners who opt for a 15-year mortgage over a 30-year one will need to make larger monthly payments but can also pay off their mortgage faster.
- Renovate strategically: Homeowners who make strategic renovations based on home improvements and additions that result in a high return on investment can increase their home’s current market value and equity.
- Let the market work for you: Homeowners who stay in their house for a long time will have a better chance of seeing their home's value increase, especially if market conditions become favorable.
How to Calculate Your Home Equity
Calculating your home equity is straightforward with the right formula. As we previously discussed, your home equity is your home’s value minus the total amount you owe on all home loans. You can calculate your home equity by using this simple equation:
Home Equity = Home’s appraised value - Total outstanding mortgage balance
By plugging in the appraised value of your home and subtracting the total balance you owe across all home loans, you can quickly get a clear picture of your current home equity.
Exploring Opportunities to Use Home Equity to Build Wealth
There are several strategies homeowners have used in the past to build wealth using their home equity. Here are a few of the more common ones:
- Home equity loan: A home equity loan is sometimes referred to as a second mortgage because it enables homeowners to borrow a lump sum of cash based on their level of equity. However, this type of loan is secured using the homeowner’s house as collateral.
- Home equity line of credit (HELOC): HELOCs give homeowners an open line of credit and allow them to access up to a defined percentage of their equity in cash. Like home equity loans, lenders secure HELOCs using a homeowner’s house as collateral.
- Cash-out refinance: A cash-out refinance allows homeowners to convert their equity into cash by taking out a larger mortgage, using it to pay off their previous one, and receiving the difference in cash.
- Real estate investment: Some homeowners may use their funds from a home equity loan or HELOC to purchase a rental or investment property or make significant renovations or improvements to their primary home.
- Other investments: Other homeowners may choose to use their funds from an equity-based investment to purchase stocks, bonds, or other financial assets. However, this type of investment comes with its own risks, as its success is highly dependent on market fluctuations.
Is Using Equity to Build Wealth a Good Idea?
Using equity to build wealth is not an inherently good or bad idea. All investments come with risks, and the only person who will know if an equity-based investment is suitable for you is yourself.
If you’re considering an equity-based investment, make sure to ask yourself these questions before proceeding:
- What does my financial situation look like?
- What are my future financial goals?
- What is my home equity?
- Will this type of investment help me reach my financial goals?
- What are the risks associated with this type of investment?
- Do these risks match my preferred risk tolerance?
Here are some other pros and cons to consider while weighing your options:
Pros
- Access to cash: Homeowners who take out a home equity loan or a HELOC can access large sums of money to pay off expenses, make extensive renovations, or consolidate debt.
- Competitive interest rates: Lenders typically offer homeowners who apply for an equity-based investment lower interest rates than they would for a standard mortgage, personal loan, or credit card because the homeowner uses their home as collateral.
- Diversified investments: Homeowners who use their home equity to invest can diversify their portfolio. For example, they could invest in real estate by purchasing a rental property or the stock market by buying shares of a Fortune 500 company.
- Tax advantages: In some instances, homeowners who pay interest on a HELOC or home equity loan can claim these interest payments on their taxes, mainly if they use the funds to improve their homes.
Cons
- Increased risk of foreclosure: Since many equity-based investments require homeowners to offer up their home as collateral, failing to repay their balance could result in foreclosure. All homeowners should consider this significant risk before partaking in any equity-based investment.
- Increased debt burden: Homeowners who take out any type of loan, even ones who borrow against their equity, will increase their overall debt burden.
- Decreased equity: Homeowners who invest their equity and take out a second mortgage will use up some of their equity, leaving less room to make additional investments or financial decisions.
- Variable interest rates: The interest rate of some equity-based investments, like HELOCs, typically varies as market conditions fluctuate. This unpredictability can create challenges for many homeowners.
- Potential loss of home value: Property values fluctuate often, sometimes without warning. If your home decreases in value, your equity will also decrease, and you may suddenly owe more on your loan than your home is worth.
Is Using Equity to Build Wealth Right For You?
Using home equity to build wealth is a viable option for some homeowners. However, no investment is one size fits all. It’s essential to approach any investment decision with caution and careful consideration. By weighing the pros and cons and understanding how the investment will affect your financial decision, you can make an informed decision that will benefit you and your family.
Some homeowners considering an equity-based investment hope to use this investment to renovate their property into their dream home. However, this course of action isn’t suitable for everyone, and it’s not the only way for you to secure the home of your dreams.
At Century Communities, we specialize in homes with modern features, spacious layouts, and convenient amenities. Use our Find Your Home feature to explore dream homes in your area.
Home Equity FAQ
What requirements do you need for a HELOC?
Most lenders have HELOC requirements, which require homeowners to have a debt-to-income ratio of 40 percent or less, a credit score of 620 or higher, and a home value that’s 15 percent more than they currently owe on their mortgage.
What’s the difference between a home equity loan and a HELOC?
A home equity loan gives homeowners a lump sum of cash with a fixed interest rate and set repayment schedule. This type of investment is ideal for one-time expenses like renovations. In contrast, a HELOC offers homeowners a revolving line of credit with a variable interest rate. This type of investment allows homeowners to borrow funds flexibly for ongoing expenses during a draw period.
Is home equity a liquid asset?
No, home equity is not a liquid asset. A liquid asset is any asset that can be converted to cash quickly, like stocks and bonds.
