How to Build Equity in Your Home in 10 Steps
Home equity is a powerful financial tool that can help you build a solid foundation for your family’s wealth that can be passed on for generations. Knowing how to build equity in your home will help you decide the best uses for that equity, and can put you on a faster path to a mortgage-free home.
What is home equity?
Home equity is how much of the home’s value you own outright. In other words, home equity is the difference between your home’s value and your current mortgage balance.
If you’re not sure how to calculate your home equity, try a home equity loan calculator to get a rough idea of how much you have access to now. You’ll need two pieces of information:
- Your home’s value. You can use a home value estimator or contact your real estate agent to request a comparative market analysis of recent home sales in your area.
- Your current mortgage balance. Your mortgage statement will show your loan balance.
Subtract your mortgage balance from your home’s value to determine your home equity amount.
How to build equity in your home in 10 steps
Any one of these steps may make a difference in how quickly you build equity.
1. Make a big down payment
A down payment is the money you pay upfront to buy a home, and the more you pay from the outset, the more equity you start with. An added bonus: The lower your loan amount, the lower your monthly payment will be, which leaves room in your budget to cover other expenses or pay extra on your mortgage so you’re building equity faster.
2. Pick a shorter term
You’ll fast track your home equity growth if you can afford the higher payment that comes with a shorter term loan. For example, choosing a 15-year versus 30-year mortgage can help you hack away at your loan balance much faster, leaving you more equity and saving you thousands in total interest charges. An added bonus: 15-year mortgage rates are usually lower than 30-year rates.
The table below shows how much more equity you have after just five years of paying a 15-year fixed-rate mortgage at 5.75%, versus a 30-year fixed-rate of 6.375% on a $300,000 loan balance. You’ll notice that the monthly payment is significantly higher, though, so make sure your budget can handle being locked into a 15-year payment schedule.
| Loan term | Home equity in 5 years | Monthly principal and interest payment |
|---|---|---|
| 30-year fixed rate | $94,574.27* | $1,871.61 |
| 15-year fixed rate | $148,048.38* | $2,491.23 |
*Based on a $375,000 sales price with a $75,000 down payment
Bottom line: By choosing a 15-year fixed loan instead of a 30-year loan, you’ll have built up more than $50,000 more in home equity after five years. But your monthly payments will also be $619.62 greater than you’d pay with a 30-year fixed loan.
3. Make extra payments as often as possible
Think about applying holiday gift money, tax refunds or bonus checks from work toward your monthly payment. You may even want to set yourself up for biweekly mortgage payments, which will knock several years off the end of your loan while you chip away at your balance a little bit faster each year.
4. Shop for the best mortgage rate possible
Studies have shown that borrowers who comparison shop for mortgage rates with at least three to five lenders save thousands over the life of their loan. A lower interest rate puts more of your monthly payment toward your loan balance instead of interest charges. Even a quarter-percentage-point difference in a rate can have a big impact on building equity in a home.
The table below compares how much equity grows after five years and 10 years on 30-year fixed-rate loans with a 6.5% and 6.25% rate, assuming you made a 20% down payment to buy a $375,000 home.
| Interest rate | Home equity in 5 years | Home equity in 10 years |
|---|---|---|
| 6.5% | $94,167.07* | $120,671.62 |
| 6.25% | $94,988.28* | $122,286.86 |
*Based on $375,000 sales price with a $75,000 down payment
A little extra effort in shopping for a lower rate helps you build:
- $812.21 of additional equity over five years
- $1,615.24 of additional equity over 10 years
You’ll need a higher credit score in 2023 to get the best conventional interest rate
The credit score bar for the best rates has been raised to 780 this year. That’s 40 points higher than the previous 740 standard, so make sure you keep credit balances low, pay everything on time and avoid opening a lot of new credit.
5. Add value with home improvements
Keep an eye on the homes selling in your area to see what kind of features buyers are willing to pay a premium for. You can also check out a cost versus value report for your ZIP code, such as the one published by Remodeling magazine, for clues to which home improvements are seeing the most return in added home equity value. Try to avoid financing the improvements with your home equity.
However, if the improvements eat into your cash reserves too much, it may be worth it to consider a home improvement loan. Some renovation loans like the FHA 203(k) loan program even allow you to finance the home improvements with a mortgage based on the estimated value of your home after the project is complete.
6. Avoid mortgage insurance
Unlike homeowners insurance, mortgage insurance doesn’t provide you with any protection against losses from damage to your home. It only protects the lender against financial losses if you default and they have to foreclose. Mortgage insurance is required if you make less than a 20% down payment on your home with a conventional loan, and it’s usually paid as part of your monthly payment in the form of private mortgage insurance (PMI).
However, there are a few ways you can reduce or eliminate PMI as your equity grows.
- Verify you have 20% equity by getting a home appraisal
- Wait until you’ve paid down to 78% of your home’s value and it drops off automatically
- Refinance your mortgage and pay the principal down to 80% of your value
7. Pay refinance closing costs out of pocket
If interest rates are lower than what you’re currently paying, a refinance allows you to replace your mortgage with a new loan at a lower rate, shorter term or different loan type. However, closing costs typically run 2% to 6% of your loan amount, and if you roll them into your loan amount you’ll be using up some of your home equity to finance those costs over the life of your loan. Try paying them out of pocket if possible to protect the home equity you’ve built up.
8. Buy mortgage points for a lower rate
If you have some extra money in the bank, you may consider paying mortgage points in exchange for a lower interest rate. However, make sure you calculate how many months it will take you to break even by dividing the total costs of the points by the monthly savings. If you don’t plan to be in the home for the number of months it will take you to recoup the cost of the points, it’s not worth it.
9. Skip government-backed loans
Loans insured or guaranteed by the government come with upfront mortgage insurance, guarantee or funding fees that are generally rolled into your loan balance, which reduces your home equity. The table below explains the programs and related fees so you can be on the lookout for these equity-shrinking charges.
| Loan type | Fee amount | What the fee is |
|---|---|---|
| FHA | 1.75% of loan amount | Upfront mortgage insurance premium (UFMIP) for most loans backed by the Federal Housing Administration (FHA) |
| VA | 0.5% to 3.6% of loan amount | Funding fee to offset taxpayers’ expense of loans made to military borrowers and backed by the U.S. Department of Veterans Affairs (VA) |
| USDA | 1% of loan amount | Guarantee fee charged for loans backed by the U.S. Department of Agriculture (USDA) to finance homes in designated rural areas for low- to moderate-income borrowers |
Use cash for upfront government loan fees or ask the seller to pay them
Although most borrowers finance the FHA UFMIP or VA funding fees, you can pay for them in cash or ask the seller to pay them. The fees are charged as a percentage of your loan amount.
10. Avoid home equity loans and HELOCs
As you’re building equity in a home, you’ll be inundated with home equity loan and home equity line of credit (HELOC) offers. If you decide to take out one of these loans, your equity will be reduced by the amount you borrow. You’ll also incur closing costs of 2% to 5% depending on the loan amount. However, home equity loans and HELOCs affect your home’s equity differently:
With a home equity loan:
- Your home equity is reduced by the full amount of the loan you borrow
- You’ll receive all of the funds at once
- You’ll usually make a fixed-rate payment and have slightly higher rates than a regular mortgage
- You won’t have any ongoing costs or fees
With a home equity line of credit:
- Your home equity is only reduced by the amount of credit used on the HELOC
- You can use the line like a credit card and pay it off during a set time frame called a draw period (usually 10 years)
- Your payment is only based on how much you use
- You may be able to make interest-only payments to keep your payment low
- You’ll have to pay the entire balance in fixed payments once the draw period ends
- You may pay ongoing maintenance and membership fees
- You may have to pay a prepayment penalty to close the loan out
Smart ways to use your home equity
Although your ultimate goal should always be to have a mortgage-free home, building equity in a home is good because there are some financial goals you can accomplish with it.
Make tax-deductible home improvements. Not only can you write off the mortgage interest for borrowing against your home equity for renovations, but when you sell the home, the basis of major improvements like room additions and or a new air conditioning system reduces your capital gains tax.
Pay off high-interest rate credit cards. If you racked up some credit cards due to unexpected expenses like a medical procedure or car repair, a home equity loan, HELOC or cash-out refinance may clear out those balances. Plus, if the cards are maxed out, paying them off may help boost your credit scores. One caveat: You can’t write off home equity loan interest unless it’s used for home improvements.
Set up a rainy reserve line of credit. Life happens, and if your emergency fund is a little low right now, a home equity line of credit may be a good backup plan. You don’t have to use the funds unless you need them. However, shop around to find HELOC lenders with the lowest ongoing fees and close-out fees.
Get rid of PMI. This may not actually involve using any of your equity. You’ll need to prove that you have 20% equity — through an appraisal or as part of a refinance — so you can stop paying monthly PMI. However, the only way to get rid of mortgage insurance on an FHA loan — if you made a down payment between 3.5% and 10% — is to refinance to a conventional mortgage.
Good news: The FHA monthly insurance premium (MIP) is cheaper in 2023.
The average FHA borrower can expect to pay $800 per year less since the Federal Housing Administration announced a reduction in the annual FHA mortgage insurance premiums. You can use the extra savings to build extra equity in your home.