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Building Home Equity: It All Adds Up

There are several ways to build home equity, not all of which are under your control. Home equity is simply the difference between your property's value and the mortgage balance(s) against it. There are several ways to accumulate home equity or accelerate the rate at which you build equity. All involve reducing your mortgage loan's balance or increasing your home's value. You can do this by:

  • Making monthly payments over many years;
  • Making extra payments to reduce the principal whenever possible;
  • Buying in an area with increasing home values;
  • Refinancing to a shorter mortgage term;
  • Improving your home to increase its value.

Mortgage Amortization: How Making Payments Works

The first thing you'll notice when you look at HSH.com's mortgage amortization schedule is that almost none of your payment initially goes toward reducing your principal balance -- it's nearly all interest. Your interest is calculated as a percentage of the remaining balance on your mortgage, so early in the process, only the small amount left over after the interest is paid gets credited toward reducing your principal. Over time, as your balance decreases, the amount allocated to reducing your loan balance increases until nearly all of your monthly payment goes toward retiring your loan.

Mortgage Prepayment Strategies

There are many strategies for increasing the rate at which you accumulate home equity. All of them involve paying more to reduce your principal balance faster. You could, for example, add an extra amount to your monthly mortgage payment. On a $200,000 mortgage at 5%, in five years you will have accumulated $16,343 in home equity. But add just $100 a month to your payment, and in five years you will have $23,143 in home equity. Another strategy is to make an extra mortgage payment each year. If you used that strategy on this same loan, making an extra payment of $1,074 each year, in five years you will have accumulated $22,291 in home equity.

Your Neighborhood and Home Values

Real estate values have historically increased at a rate similar to inflation -- according to the FDIC, home values have increased at an annual rate of about 5%. Unless you're in a booming or busting area, that sort of modest increase is fairly typical over time. However, given today's market conditions, it's better to expect perhaps 3% rather than 5%. So, if you take that $200,000 mortgage and assume that the buyer put 20% down, you begin with a property value of $240,000. In five years, the estimated property value is $308,006. So if you make the regular scheduled monthly payments, you'd owe $183,657 and have home equity totaling $124,349 (or $308,006 less the mortgage balance of $183,657).

How Mortgage Refinancing Affects Your Equity Position

Refinancing can help you build home equity -- or it can skim it right off. Since refinancing costs can often be rolled into the new mortgage, you might not realize their impact. For example, if that $200,000 home loan has a 5% interest rate, but the lowest mortgage rate you can get is now 4%, refinancing is not a no-brainer.

If you have been paying your home loan for five years (you still owe $183,657) and can get a 4% interest rate which costs you three points (3% of the loan balance, some $5,509.71), plus $3,000 in closing costs, you take a big financial step backward. Use HSH.com's refinance calculator and you'll see why: your payment will drop to from $1,074 to $917 due to a lower rate and restarting a 30-year term, but your loan balance increases by $8,510, so your new loan at 4% starts with a balance of $192,167.

Since you've started a new 30-year mortgage, you'll be paying off your mortgage an extra five years. Doing this will improve your cash flow. However, comparing the total interest cost of your original mortgage (over 30 years) versus the total interest costs of the first five years of your existing loan plus the cost of your new mortgage (a total of 35 years) is nearly identical, which means you have't actually saved any money at all. Extending the term of your loan re-starts the "equity clock", which means it will take longer to build or rebuild the equity in your home.

What if you can shorten the term? If you can refinance to a 15-year term, a 4% rate will cost less in fees and you pay off your loan sooner. A shorter terms means that your monthly payment will increase, in this case to $1,394. However, that "forced" prepayment means that you'd be done ten years earlier than if you hadn't refinanced, and since getting that new rate might only cost one point ($1,865) plus $3,000, you'll save over $75,000 in interest cost... and you'll have 100% ownership (that is, 100% equity in our home) some ten years sooner than if you didn't make the change.

Improving Your Home to Increase Home Equity

Very few major improvements offer a return greater than the cost to make them. That is, you generally won't get back all of the money you invest in a home improvement project. According to many real estate experts, generally, renovations that pay off the most are changes that correct defects that make your home less desirable and/or valuable relative to others in your neighborhood. For example, if everyone else on your block has three bathrooms and you only have one, you may need to do some updating. The good news, though, is that many improvements that offer the greatest return on your investment can also be the cheapest. Check out this list from Seeking Alpha:

1. Clean up your act (973% average return on investment). Expand your storage options or get rid of things you have no room for. A professional cleaning can make your home stand out when competing for buyers.

2. Lighten up (865% average return on investment). Replaced all broken lights and burned out bulbs. Have skylights and windows cleaned.

3. Yard improvement (426% average return on investment). Store anything that doesn't improve your yard's aesthetics -- equipment, extra cars, clotheslines, etc. Have a gardener or landscaper trim everything, get the grass in shape, and add flowers, trees, or plants as needed.

4. Plumbing and electrical (260% average return on investment). Repair or replace defective plumbing. Otherwise you have to disclose problems and potential buyers may shy away.

5. Kitchen and bath freshening (168% average return on investment). This doesn't have to be a huge project--resurface cabinets or repaint. Replace anything dingy or dated: toilet seats, fixtures, drawer or cabinet handles. Clean, caulk, and redo grout in sinks, tubs, showers, and on countertops.

6. Interior paint (148% average return on investment). Repair and patch damaged interior walls, then touch up or repaint them in a neutral color.

7. Replace or clean carpets (104% average return on investment). Professional cleaning may suffice if they're not heavily worn or soiled. Otherwise, replace them.

8. Flooring (101% average return on investment). Refinish or repair damaged or worn floors. You may also choose to cover them with carpeting.

9. Exterior paint (76% average return on investment). Redo the exterior surfaces for instant brightening. Your home's curb appeal affects its value.

There are many ways to build home equity. Take charge of what you can control for a better financial future.

Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian and as an accountant for Deloitte.

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More help from HSH.com

  • Home equity borrowing basics

    Our new Guide to Home Equity Loans and Lines of Credit (HELOCs) starts here.
  • Accessing your home equity

    This first article of Section II of our Guide to Home Equity Loans and Lines of Credit looks at the various ways lenders allow you to access your home equity, and discusses key differences between loans and lines.
  • Determining how much home equity you can borrow

    Article 3 of Section I of HSH.com's Guide to Home Equity Loans and lines of credit, we explain how to reckon your equity stake and discuss criteria lenders use to decide how much they'll lend to you.
  • Using home equity

    This is the second article within Section I of HSH.com's Guide to Home Equity Loans and Lines of Credit. In it, we discuss some common and valuable uses of your home's equity, and some you may want to avoid.
  • Understanding home equity

    This is the first article within Section I of HSH.com's Guide to Home Equity Loans and Lines of Credit. In it, we explain what home equity is, how you get it, how you can build it and why you should protect it.

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