Equity is one of those words that’s frequently thrown around, everyone nods along in agreement, then we walk away slightly confused. It’s a little ambiguous – you can’t define it just based on context. And it’s not something that’s often covered in school. But it’s actually hugely important! And equity helps to explain why people lost their homes during the Financial Crisis. What is equity? How do you get it? And why do you care? Keep reading to learn more!

What the heck is it?

Equity is the amount of actual ownership you have built up in something – for our purposes, that something is going to be a house. When you buy a house, you are more than likely going to be taking a mortgage out (how often do you have an extra $300k in cash laying around, am I right?). While not all mortgage products require a down payment, the vast majority do.

To make the numbers easy, let’s say you put 5% down on a house that you purchased for $400,000. That means, you own 5% of that house outright. Technically, the bank still owns the other 95% of the house and you are going to be paying them back to gain that equity (or ownership). The end goal is obviously to pay up your entire mortgage and now have 100% equity built up – meaning you own the entirely of the house.

Equity sounds great! How do I get it?

The first way to gain equity is with your down payment upon purchasing a house. This is money you are putting down in cash and it is directly reducing the amount you borrow from a bank (i.e. your loan amount). The more money you put down for a down payment, the more house you own and the more equity you have starting off.

Another way to obtain equity is through the appraised value of a home. This requires a bit of luck and being in the right place at the right time. Whenever you are working through the mortgage process, your loan officer is required to order an appraisal on your home – you can’t get financing without one! This appraisal tells the bank whether or not the house is reasonable worth what you are buying it for. This protects both you and the bank – you don’t want to be underwater, paying more for a house than it’s worth, before you even move in!

There are definitely times when your agent is expecting the house to appraise for more than you are paying for it (meaning you are buying the house at a discount). Perhaps the seller needs to move quickly so they lowered the price to generate more interest so they can get an offer and close ASAP. Or maybe their real estate agent used inaccurate comparable homes so they priced the house lower than necessary. There are a lot of reasons why a house would appraise higher than the purchase price. At the end of the day, a higher value means more equity built into the house. If you buy a house for $200,000 but it’s actually worth $250,000 – guess what? You now own $50,000 extra of that house!

You can also gain equity through home improvements. This runs tangent with your home appraising for more. Generally speaking, home improvements that are appealing to the mass market will increase the amount of money someone is willing to buy your house for (i.e. – increase the appraised value). Maybe you decide to gut the super outdated kitchen and replace it with a modernized one for $10,000? That $10,000 up front investment could end up translating to an extra $20,000 being added to the home’s value (this obviously varies on a case by case basis).

Why do we even care?

I think a lot of people talk about equity and have a general understanding that it’s a good thing to have, but there is a disconnect on WHY it’s good. Your home’s equity can literally be put to work for you. I think the most powerful example is in refinancing your home – specifically in doing a cash out refinance. This is where you actually pull money out of your house. You get a new mortgage by refinancing but you also get a big check at closing that comes from the equity in your house. The more equity you have, the more money you are able to pull out.

This is so important because your house can be used to pay off credit card debt when your interest rates get too high. You can pull cash out for home renovations (which could in turn add even more value to your house – CHA CHING). If you graduate with lots of student loans, your house can help to pay those down or even pay them off completely. Your house can do more than put a roof over your head. If you aren’t sure if a refinance is right for you, contact us today and we’ll give you an honest assessment. If we don’t think refinancing will be beneficial in the long run, we’ll let you know.

On the flip side, there is such a thing as negative equity. This concept was running rampant leading up to the financial crisis. Not only would you not have equity in a home, but you actually owe MORE than this house is worth. Some refer to this as being “underwater”. There was a general consensus that real estate values would always increase – mostly because there was a steady increase for a number of years leading up to the crisis. People felt comfortable borrowing more than a house was worth at that time, because everyone (banks included) assumed the home value would increase. There’s no harm in hoping your house will increase in value. But borrowing more than your house is currently worth, without any guarantee that it will be worth more, is not a risk worth taking. There are a lot more checks and balances in the mortgage world today, so it would be very difficult to land yourself in that position today.

Ending Thoughts

Equity can quickly be summed up as the amount you actually own of your home. Whether you obtained that through a down payment, paying down your mortgage or increasing the appraised value – you have equity! Your equity can be a huge help in paying off other debts (like credit cards or student loans) and it can be used for those home renovations you’ve always wanted. Not sure if refinancing is right for you? Talk to a licensed loan officer today!