You’re a good comparative shopper. From the grocery store to the financial calculator, you’re sizing up your options and making the wise choice for your wallet. Naturally, when looking at whether it makes sense to rent a place or buy a home, you do your research. And when you do, you keep finding people talking about “building equity” as a good reason to buy a house. Why? What’s so special about this equity business?
What is Home Equity?
You can think of Home Equity as the amount of the property you own that’s left when you take away the amount of the debt you have against it. For example, the red section below is the home’s equity:
A mortgage is a loan where you use your property as collateral, meaning if you fail to pay your debt, you hand over your property instead. That’s called Foreclosure and is generally considered no fun so let’s imagine for this example that you do continue to pay your bills.
Every time you pay that mortgage, a portion of that money goes toward the principal balance (there are mortgage programs that don’t work like this but they’re specialized “interest only” mortgage products and we’re going to assume that you didn’t get one of those for the sake of this example). Principal Balance is a fun way of saying “the amount that you borrowed.”
So, every time you make a payment, the amount that you borrowed goes down a little bit. It’s a trickle at first, but as time goes by that widens to a stream and your principal balance really starts shrinking.
The retail value of your property (meaning how much you could sell it for) will fluctuate with the mood of the markets and home buyer seasons, but history says that eventually that value should go up. Your potential selling price goes up while the amount that you owe gets paid down. This difference is your home equity.
What Does This Have to Do Deciding Whether to Rent or Buy?
The simplest way to look at home equity is as an investment. Instead of putting your money in the stock market or a savings account, you’re investing in your property. That’s why people talk about home equity when they’re comparing renting against buying. When you rent, your money is covering someone else’s mortgage, if they have one. They are the one building equity on the property that you’re living in.
What is Home Equity Good For?
That is a question with many possible answers. Some people pay off their mortgage and live happily ever after knowing that they have that equity there should they need to draw money against it in case of an emergency, college tuitions, etc. Some people choose to draw on their equity through refinancing or adding a home equity loan or home equity line of credit, which can be less expensive options than credit cards. One person’s needs and goals will be different from the next but building equity is a nice way to keep options open in case of those life events with large dollars signs attached.