Equity explained

October 5, 2021 Icon 4 mins read
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Photo by Hutomo Abrianto on Unsplash

You may have heard people talk about “equity” before, in relation to buying a home. But what exactly is equity? And why is it so important? In this article, we’ll be explaining equity and what it means for you.

Home equity

Equity is, in a sentence, the portion of your home that you “own”.

It’s the difference between what you owe your lender and the property’s current value. It comprises the amount you’ve paid off, plus your deposit.

What’s more, if your home rises in value, then this also includes the difference between the price you paid when you bought the home, and how much you could sell it for now.

Paying back your mortgage increases your equity.

Why is it important?

Equity in your home is a measure of your accumulated wealth. Ideally, you want your equity to be positive. If you have negative equity on your home, you will not be able to sell it for the same amount that you bought it, since a large portion of the money goes to the lender.

It takes time to build equity on your home, because it is dependent not just on your mortgage, but also on the wider housing market. The value of your home can depreciate even when you’ve paid off more than half your mortgage. Even once you’ve completely paid off your mortgage, your home’s overall value is still tied to the market.

What can I use it for?

Once you’ve paid off your mortgage, you can use the equity to get a lump sum, or a steady stream of income. Often, people over the age of 55 arrange for something called “equity release”. There are two ways of doing this:

First, you could take out a mortgage on the value of your home. This liquefies the cash that is tied up in your home and allows you to put it towards other things.

Second, if you’re over 65, you could apply for a “home reversion”. You sell a stake in your home to a provider who pays you a tax-free lump sum in return. The provider will allow you to keep living in the house rent-free. When you die and your home goes back on the market, the provider will ask your heirs to hand over a portion of the sale equivalent to their stake in the home.

Pitfalls

Bear in mind that equity is just as important in inheritance. If you go through with release when you’re still alive, your heirs will not receive as much as they otherwise would. On the other hand, it does improve your standard of living while you’re still alive.

You should always seek proper financial advice before you go through with something as serious as equity release.

How do I build equity?

This is a question with a complicated answer, as discussed above. However, the main points are that you need to be reducing your debt as fast as you can. Mortgages with large deposits already put you at an advantage, so it pays to save before you buy.

Making overpayments can also help reduce your outstanding balance and therefore your interest. However, bear in mind that some mortgage types disincentivise and even punish you for making overpayments, so be sure that overpaying won’t hurt you financially.

Lastly, remember that a house is an investment, just like buying stocks and shares in a company, and therefore, it makes more long-term financial sense to direct money you receive outside of your regular income – bonuses, windfalls, lottery winnings – into paying off your mortgage, which in turn greatly builds the value of your estate.

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Robert Edwards

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