Knowing what equity is is important. Understanding how equity fits into all of your finances and calculations for the future is essential. That is why, in this article, we’ll explain what equity is, then follow up by explaining how understanding equity can help you make better plans for the future and build your wealth. Equity is fairly easy to understand.
Equity is How Much You Own of Your Home
Just about anyone who has bought a home knows at least this much about equity. If you bought a home for $200k and made a $40k down payment, you would have $40,000 of equity in your home. Equity is just a fancy term for how much of your hard-earned cash you have converted into ownership of your plot of land and the conglomerate of wood, bricks, and concrete situated on it. Equity is calculated by taking the fair market value of the home (determined by a licensed appraiser) and subtracting the amount you still owe on it. In the above example, the home is worth $200k and you still owe $160k. Subtract them and you have the amount you have already paid off: the amount of equity you have.
How You Increase in Equity
You may have heard the term ‘PITI’ payment. In case you have not, it stands for “principal, interest, taxes, and insurance”. Your PITI payment is the full monthly payment that’s due each month and includes everything that makes up the payment. Only one of those four things contributes to the equity you have in your home: principal. If you want to know how much equity you’re building in your home each month, take a look at your mortgage statement. It will show you how much of your monthly payment is going towards principal. If you’re in the first few years of a 30-year fixed, that number is going to be depressingly low. The fastest way to increase in equity is to get the lowest APR you can find and make more than the minimum payment. Any amount above the minimum that you pay goes towards paying off principal on the home.
How Understanding Equity Helps your Finances
Sure, you’re paying for the privilege of living in the space for a month, but it’s even less forgiving on your finances than splurging on the latest smartphone, tablet, and laptop every couple of months because at least you can sell your electronics and recoup some of the costs. When you leave the home you’ve been renting, all you’ll get is your security deposit, and even that’s not a guarantee. What makes buying a home better for your finances? Equity. When you make your monthly payment on a home you have bought, a portion of the payment is going from one asset (your bank account) to another (your home). You’re still throwing some money away on taxes, insurance, and interest, but you keep as much as you put into your home.
Your Home is a Bank Account
Equity makes your home like a bank account; you deposit money into it each month in equity, and you can withdraw from it by selling your house, doing a cash-out refinance, or in even more creative ways like renting out the basement or using part of the space to start a home-based business. In fact, putting money in your home is much better than putting your money in a savings account, at least as far as ROI (return on investment) is considered. On average, home prices have increased by 3.1% per year over the last 100 years. In other words, your home ‘bank account’ is earning 3.1% interest, while your savings account is earning less than 1%. Granted, while your home is increasing in value, you’re paying through the nose in interest to your lender. That’s why, as a veteran, you really should go with something like the hybrid ARM or a 15-year fixed instead of a 30-year fixed.