Building equity is one of the biggest advantages of buying a home. Over the course of your loan, you make mortgage payments on the principle and interest. “Equity” is the difference between your home’s current market value and the amount of principle you owe.
Thinking of buying a home to build equity but not sure if it’s the right decision for you?Something real estate experts call the “Five Year Rule” can be a useful guide.
The Five Year Rule is that you don’t want to buy a home unless you plan to stay in it for at least five years. Otherwise, you won’t build enough equity to make buying the home worth it in the first place.
How Long Does It Take to Build Home Equity?
When you take out a 30-year mortgage, the vast majority of your monthly mortgage payment is going to go toward interest charges for the first few years of the loan. At first, you’ll likely owe more on the loan than the home is worth. Due to the interest payments you have to make, so you might not have any equity after 1-3 years.
The Five Year Rule says that it usually takes five years to start building substantial equity in your home—after five years of payments, you’ve paid off a lot of interest and begin to get some real traction in building equity. So the five-year mark is generally considered the point where your accumulated equity begins to exceed what you might have saved by renting, though it may vary depending on the terms of your loan and the cost of renting vs. buying in your area.
Suppose you buy a home with a $200,000 mortgage with a fixed rate of 4.5 over 30 years. In the first year, nearly three-quarters of your monthly $1000 mortgage payment (plus taxes and insurance) will go toward interest payments on the loan. With that loan, after five years you’ll have paid the balance down to about $182,000—or $18,000 in equity.
Assume that instead of buying, you rented the same home for $700 a month. After 5 years of payments you would have spent $42,000 (60 months x $700). Renting would have saved you $18,000 compared to a mortgage payment, but you wouldn’t have accumulated any equity in that time.
How to Build Equity Faster Than Five Years
If you could build equity more quickly—thereby negating the higher month-to-month cost of owning vs. renting—it might be financially worthwhile to trade out of a home sooner than five years. Here are some ways to build equity faster.
Purchase at the Beginning of a Rising Home Market
In a rising home market, you may find that home values are increasing fast enough that the appreciation alone is enough to exceed the expense of interest payments and closing costs in just two or three years.
Of course, that isn’t a reliable way of building value. While home values do tend to rise in value over time, it isn’t consistent enough to be able to depend on it over just a five-year period. And in the worst case scenario of a home market crash, you could end up going underwater on your loan.
Make Extra Payments On the Loan Principal
You could build equity more quickly by simply paying an additional sum on top of your required mortgage payment each month—whether that’s $50, $200, or more. Paying down the interest faster will mean that you will be able to pay down the principal of your loan faster, too, and that’s when you start to build more equity.
This isn’t necessarily a better option than renting, however. Because this money is coming out of your pocket, it could have just as easily been deposited in a savings account if you were renting, and that could be a more reliable, low-risk way of making money. Still, if you’re passionate about having a home, making extra payments is a good way to build equity faster.
Use Sweat Equity
“Sweat equity” refers to the increase in a property’s value due to improvements or renovations made by the homeowner through their own labor and skills, rather than through monetary investments.
A more reliable way to build equity quickly is to buy a home that needs some work done to it and make those improvements or remodels yourself. That way, you can increase the value of the property and realize a gain when selling the home only 2-3 years later.
This type of approach can work if you have the skills and knowledge to make most of the improvements yourself. People who are knowledgeable about construction and real estate can often make this work by contracting out all the improvements, but the margin for error is much thinner there. The more of the work you can do yourself, the less you’re paying out of pocket. But this approach isn’t for everyone.