Understanding equity

Many people think of houses as places to live. To them, a house functions mainly a residence, a place to lay their head. Houses also serve another important function: equity, or wealth tied up in the ownership of your home.

Equity represents the portion of your house that you own, or the portion of the market value that you have paid for. To take one example, consider Brian, whose house is worth $200,000. He put down a $40,000 down payment and has been paying the remainder through a mortgage. After many years of prompt monthly payments, Brian’s mortgage principal has been paid down to $100,000. His equity, then, equals $100,000.

Home loans are usually designed according to an amortization schedule. In the first years of your mortgage, a large part of your monthly payment will be used to pay the interest on your loan. In later years, more of the payment will be used to pay down the principal. As a result, equity builds faster in the later years of your mortgage.

As you build equity, you create a store of wealth that you can borrow against later. After they hold considerable equity, many homeowners choose to open a line of credit that frees up cash for major purchases. Other times, borrowers will elect for cash-out refinance loans, which free up cash in a somewhat different way. Equity can be a useful line of credit because interest rates are low. Moreover, the interest is tax deductible.

Ultimately, you should think of your house as a place in which to live and a storage site for wealth. Not many things in life serve two functions of such magnanimous importance!