What Does Equity on a House Mean? Maximizing This Wealth Builder

Equity on a house is an asset. It can increase your net worth and help you build generational wealth you can pass down to your heirs. Understand how home equity works to maximize it to improve your finances.

What Is Equity on a House?

Home equity is the difference between your house’s fair market value and its liens — legal claims permitting their holders to use your property to recover what you owe to them.

Say you own a detached single-family house that could sell for $400,000. If your outstanding mortgage balance were $250,000, your equity would be $150,000. If you sold your property for $400,000, the $250,000 would go toward your mortgage holder to zero out what you owe, and you could pocket the remainder.

How Does Equity in Your House Work?

The equity on your house can increase or decrease because of property appreciation and mortgage principal repayment.

Houses become more valuable over time due to location and inflation. Economic conditions — such as more job opportunities and better living standards — compel people to live in specific areas. Attractive places witness a spike in demand for housing. Home prices go up when demand outpaces supply, allowing you to gain equity without doing anything.

Properties generally appreciate passively. However, you can actively boost your home’s value by ensuring its features are desirable to most when you sell it. For instance, your house can fetch above the market when you modernize its plumbing and electrical systems.

Another way to actively increase your home equity is to pay down your mortgage principal — the original amount you borrowed. The less principal there is, the more you own in your property.

Home loans have different amortization schedules. In a fixed-rate mortgage, your principal decreases more quickly halfway through the term because most of your initial monthly payments go toward the interest. Still, you can reduce your principal more quickly by paying extra every time.

The principal dictates the interest amount. The faster you zero down the principal, the less interest you pay. Although your mortgage contract may penalize you for paying down your home loan sooner, it may be worth the expense because you can save on interest significantly and grow your home equity quickly.

Paying down your mortgage principal doesn’t guarantee equity generation, though. Your home loan may sink underwater when your property value drops lower than what you owe. Negative equity can cause you to sell your house at a loss. Putting down as much money as possible can decrease the chances of you becoming upside down on your mortgage.

How Do You Use Home Equity?

You can cash out on your home equity without selling your physical asset — your house. It generally entails taking out a loan. You can receive a lump sum you can spend on whatever you fancy by refinancing your mortgage or applying for a home equity loan. Alternatively, you can open a home equity line of credit, enabling you to draw funds within a predetermined period as you please.

How you use the cash derived from your equity determines whether it can better your finances. Consider these five tips to maximize it to improve your quality of life.

1. Pay Off Other Debts

Taking on a debt to zero out your more expensive debts is a surefire way to reduce your expenses in the long run.

If the maximum amount of equity you can turn into cash is big enough to settle all your financial obligations — such as credit cards, student debt and auto loan — use your house as an ATM to wipe them out. Ultimately, you’ll only deal with one cheaper debt.

If you can’t consolidate all your debts with your equity, prioritize. Enumerate the things you owe by outstanding balance and interest rate. You can do the snowball method, eliminating the smallest ones first and enjoying fulfillment by reducing your total number of debts. You can take the avalanche route, where you pay off the ones with the highest interest because they cost you the most.

Either way, if you refrain from accumulating new bad debt in the future, you should be in better financial standing.

2. Reinvest in Home Improvement

Funding a renovation can be a wise way to take advantage of your equity. Home improvement is a tried-and-true driver of property appreciation. Updating your house can increase its perceived value and convince interested buyers to bid higher when you put it on the market.

However, most home projects don’t generate a 100% return. If you revamp your kitchen for $28,000, expect others to pay less than the final job cost. The 2024 Cost vs. Value report indicates that costlier upgrades tend to have lower returns.

Trends come and go, so using the hottest renovations as your guide when improving your home may disappoint you come resale time. Beauty is subjective — focus on security, energy efficiency and climate resilience instead.

3. Hold Liquid Appreciating Assets

While real estate can increase your net worth, it’s illiquid — challenging to convert into cash when needed. Tapping some equity on your house to acquire liquid assets, such as stocks, bonds, mutual funds and cryptocurrencies, allows you to grow a portion of your wealth passively and turn it into dollars more quickly.

The caveat is that liquid assets can decrease in value over time. They may also be subject to capital gains tax when you sell them.

4. Acquire a Rental

Unlocking home equity to buy an income-generating piece of real estate, like an apartment unit, can be a stroke of genius. Using the sum to pay a 20% down payment or more can help you build equity on your new property faster and avoid private mortgage insurance — an extra expense that doesn’t benefit you.

However, being a landlord isn’t a walk in the park. You should treat your rental as a business that it is by familiarizing yourself with all relevant laws and corresponding expenses.

5. Supplement Your Income

If you’re in your twilight years seeking an additional income, borrowing against your property through a reverse mortgage may suit you. This home loan’s repayment only kicks in when you permanently move out, sell your property or pass away. You can get paid through a lump sum, smaller monthly payments or a combination of both.

Applying for a reverse mortgage may deprive your loved ones of inheriting your house when the time comes. Receive counseling before pulling the trigger to understand its implications and calculate its risks.

Use the Equity on Your House Wisely

Building considerable equity involves time, luck and a series of sound decisions. You may only have one chance to cash out on this asset in your life. Touch it prudently to avoid seeing it go to waste.