When homeowners purchase their first home, their equity is usually small. Home equity is the difference between the home's value and the amount owed on any mortgages, so unless the buyer made a large down payment, the amount of equity will be small, usually on the order of 5 - 20%. (A home that is owned free and clear has 100% equity.)
As they pay down their loans, however, equity will often increase, due to the fact that the amount owed is smaller, and also due to an appreciation in property value (hopefully). 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 risk-free, 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 goals you may have.
Whatever equity you started out with, it is important to build it quickly. For many decades, you could count on steady increases in home values in many parts of the country to help you build equity. But in the middle of 2007, those guarantees came to an end as home values started to plummet. While values are rebounding in most places, you can't count on spectacular price increases in home values anymore.
To build equity, you may have to do it the old fashioned way - by paying for it!
Building equity isn't just important for the long term. At some point in time, you may want to sell your home and buy another one. Remember, if you sell your current home, you'll likely have to pay a 6% commission to the real estate company that helps you sell it. With normal amortization on a 30 year loan, however, the mortgage balance won't have been paid down to 94% of its original value until after 4 years have passed. Having equity will allow you be flexible in your selling price, and will also make it easier to quality for a new mortgage since you will have more money available for a down payment on your next home.
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.
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.