Home Equity: How to Build it, How to Use it
When homeowners purchase their first home, their equity is small. The only equity may be just the initial down payment, which is perhaps only 5% or 10% of the value. Or it maybe nothing, as is the case with people who bought with “no money down” in the recent days of profligate lending.
During the next 30 or so years, equity increases as a result of appreciation in property value and by slowly paying down the mortgage balance. A worthy goal for many people is to maximize their home equity by the time they retire. In fact, for many people, building equity in their home is a simple and relatively painless way to increase their net worth.
Indeed, for those who have modest retirement benefits, building substantial equity holds the key to a successful retirement. This series will focus on developing strategies to assure, first, that you maximize your equity in the manner most suitable for your situation, and second, to consider how you can use equity to further other purposes you may have.
Building Equity after Buying
Whatever equity you started out with, it is important to build it quickly. At the current date, mid-2007, we have come to the end of a period of spectacular increases in real estate values. Lots of homeowners were beneficiaries of this. Today, you can't count on that and equity may have to be built the old fashioned way -- by paying for it!
At some point in time you may want to sell your home and buy another one. It will be important to be able to take as much equity as you can with you to your new home. This isn't easy when you start out having to pay a 6% real estate commission. Don't assume that you can sell without a broker. You may get lucky, but maybe not!
If you bought your home with no money down, you have to scratch up 6% equity just to get out with no money. With normal amortization on a 30 year loan, the mortgage balance won't have been paid down to 94% of its original value until after 4 years have passed. For those who got the popular Interest-Only loans, they never will get there!
Bottom line: You need to manage your mortgage debt by paying it down so as to meet your objective. I know that all borrowers stretch in making mortgage payments, particularly on their first home, and here I am talking about increasing the monthly payment. But that's reality and you need to deal with it. If you get lucky, we'll see renewed appreciation and you'll get a little help.
There are many calculators on the Internet that can help you figure out a plan to meet your objectives. Try the ones at http://www.mtgprofessor.com/calculators.htm
Building Equity for Retirement
Your Sure Fire Happy Retirement Plan is to pay off your mortgage the month you retire. Your income will drop when you retire, but when you also eliminate the largest expense item in the budget, retirement can be a joy.
However, one of the funny things about time is how quickly it passes. All of a sudden, you're 60 years old and you “forgot” to make those extra principal payments you talked about and you still have a hefty mortgage balance. Owning your home free-and-clear, as the expression goes, sound pretty good. With a plan, you're likely to achieve your goal, so let's talk about goals and planning.
To achieve this goal, you must start years earlier. You've seen the examples that show the advantage of starting to contribute to your 401(k) in your twenties rather than later in your career. The mortgage payoff plan is no different. Ideally, the plan should be implemented when you are just entering your fifties, if not before.
Your income is close to its peak and your expenses are down after launching your kids. You're comfortable with your monthly mortgage payment but you now have more disposable income. That's the time to increase your payment to a level that will have the loan paid off at a specific time in the future. Let's work through an example.
Say you and your spouse are 47 years old and you want to have your mortgage paid off when you are 63 years old, 16 years into the future. Let's assume that you got a 6% $250,000 30-year loan seven years ago. The payment is $1,499 per month. The current balance is $224,088 but if you don't do something different, it wouldn't be paid off until you were 70. By increasing the payment to $1,818 per month, you can reduce the length of the loan to 16 years. In addition, because you've paid the loan down faster, you save a total $64,500 in interest over that 16 year period. All that went to paying down the principal faster.
Sometimes you can hasten this process by refinancing. In the next article in this series, we'll explore the costs and benefits of refinancing and discuss how you can decide if it makes sense for you.
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