What the Heck is Equity?

Many of the people I’ve discussed first-time home buying with recently are hyper-focused on interest rates. There is a misconception that they are better off waiting to buy a home until interest rates come down. Although lower interest rates equate to increased buying power and/or lower monthly payments, many of these people aren’t considering one of the biggest benefits of homeownership when they compare buying to renting: equity.

So, besides a buzzword that real estate professionals love to throw around, what is equity?

Simply defined, equity is the difference between what your home is worth and what you still owe on your mortgage. For example:

Home value:              $400,000
- Mortgage balance: - $300,000
= Equity:               = $100,000

That $100,000 is your ownership stake in the property.

There are two primary ways homeowners build equity. First, homeowners build equity when they pay their mortgage each month. While part of their payment is going towards interest, property taxes, and insurance, another portion is going towards principal. Every dollar that goes towards principal pays down their loan and increases their equity, or their outright ownership of their home. On the other hand, when renters pay their landlords each month, that money goes into the landlords’ pockets, and no ownership stake or equity is built.

The second way equity increases is through appreciation. Real estate values have historically appreciated over time. While markets can fluctuate in the short term, long-term homeownership has often allowed homeowners to benefit from increases in property value.

I personally like to consider my equity as a form of an illiquid savings account or additional investment in my portfolio that grows as my house appreciates and each time I make a mortgage payment. This way of thinking helps conceptualize how homeownership can help individuals build wealth. For many families, home equity becomes one of their largest financial assets over time.

For example, I recently met with a client to review a fees worksheet that demonstrated that she could buy a $425K condo, similar in size to her current apartment, with a 10% down payment, and her monthly housing expense would be the same as her current rent. To buy, she would need to spend around $50K cash on the down payment and closing costs.

So, why would she buy if she got the same type of property for the same monthly payment, but would have to spend $50K of her cash to do so? Should she wait for interest rates to come down so she has increased buying power, or so the monthly payment for a similar property could be below her current rent?

To answer these questions, I used a “rent or buy” calculator to determine if the costs of renting for five years outweighed the costs of owning, offset by the equity she would build over those five years. Renting would cost nearly $90K more than owning. After accounting for the $50k cash to buy, this client would be nearly $40K better off financially if they were to buy today.

This benefit doesn’t even account for the potential for this client to refinance if interest rates drop during that five-year period, thereby lowering her monthly payment. I wouldn’t hold my breath for a landlord to lower rents.

Also, equity is not just a number on paper. It can also become a financial tool. Through options like cash-out refinances, home equity loans, or home equity lines of credit, homeowners can leverage their equity for things like home renovations, high-interest debt consolidation, emergency expenses, or business start-up costs. In other words, their equity allows them access to cash at lower interest rates as compared to relying on credit cards or personal loans.

For many people, homeownership is about more than just having a place to live. It is also a long-term financial strategy that allows them to build equity and create future opportunities. Whether you are thinking about buying your first home to begin building your own equity or already own and want to explore leveraging your home equity, don’t hesitate to reach out to us. We are here to help!