Build Home Equity Faster
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 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. Repeat home buyers usually rely to some extent on the equity in their current home to help buy their next home. The more equity you have, the larger the possible down payment for the trade-up home.
Home equity also equals security. The more you have, the better off you are, the more financial leverage you have, the more stable you feel. So how do you build home equity faster? Especially at the beginning of a mortgage loan, so little of your payment goes to principal 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.
To compare this option to other ways of building your financial security, let’s look at additional principal payments in contrast to investing. Additional principal payments make sense when you save more on your mortgage interest expense on an after-tax basis than you would earn on your investments on an after-tax basis. If you are able to deduct your mortgage interest from your income taxes and your marginal federal income tax rate is 27 percent or higher, then your after-tax cost of mortgage debt is between 3 and 4 percent.
In the current economy with its low interest rates, the after-tax return on money market investments and CDs won’t offset your after-tax cost of debt. For instance, if you earn 4 percent pretax on a five-year CD, and you're in the 27-percent bracket for federal income taxes, the after-tax return is less than 3 percent.
However, contributing to a tax-advantaged retirement account, especially a 401(k) plan where your employer matches all or part of your contributions, can be a better strategy than prepaying your mortgage -- at least up to the limit of the employer match.
Before you start making additional principal payments, use one of the many amortization calculators you can find on the internet to do the math—how much interest you would save if you made additional principal payments, and how much it would shorten your loan and increase your home equity.
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. But you can also refinance to shorten the term of your mortgage, which builds equity. The down side to this is that a 15-year mortgage is harder to qualify for than a 30-year.
If you had a $200,000 30-year ARM at 8.13 percent and replaced it with a 15-year fixed rate loan at 6.75 percent, your monthly payment would go from $1485.69 to $1769.82. But the total interest on the 15-year loan will come to $118,567.29 as opposed to the $334.855.28 on the remaining life of the ARM, assuming your adjustable rate holds steady at its current 8.13 percent. So in addition to saving more than $200,000(!), you build the same amount of equity in half the time.
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.
You probably won't receive the entire amount of your equity as cash when you sell your home. Most sellers use part of their equity to pay selling costs, such as brokerage commissions and transfer taxes. Also, if you are delinquent on your property taxes, or have other liens secured against the property, such as an IRS tax lien, these would have to be paid at closing.
In past years, homeowners saw their equity grow significantly due to home price appreciation. Appreciation is the increase in the value of a property. Picture this: You bought your first home for $125,000 in 1985 with a 10 percent down payment of $12,500, and a mortgage for $112,500. By 1989, your property had doubled in value to $250,000. After you paid back the mortgage and your selling costs, you were left with about $122,000 in cash.
For more information, please contact Lani Adams at Lani.Adams@cbdfw.com