One of the main benefits of being a real estate investor is the opportunity for building equity in your rental property. Equity in real estate is simply the difference between what your investment property is worth and what you owe on your mortgage. Learning how to calculate equity in real estate is very important for every real estate investor. For instance, if you own a property worth $300,000 and you owe $50,000 on the mortgage, your equity is $250,000.
However, it is important to note that equity only exists on paper. To take advantage of it, you will need to borrow against it or sell the income property.
Why Is It Important to Build Equity?
Equity is a very useful financial tool for anyone owning investment property. Here are some of the reasons why building equity in your property is important:
1. Buying a new investment property using equity
If you are planning to sell your rental property and buy a new one, equity can be your best friend. Let’s say the property you are selling has appreciated in value and is now worth $310,000. And you’ve built $100,000 worth of equity in it. If you sell the property at its market value, you will end up making a profit from it. Keep in mind that you will incur some charges such as mortgage closing costs and your real estate agent commissions. Still, you will be left with a good sum which you can use to make a substantial down payment for your next investment property.
Related: Rely on Equity or Take Out a New Mortgage?
2. Borrowing against equity
When it comes to borrowing against your investment property’s equity, there are three options; a cash-out refinance, a home equity line of credit or a home equity loan.
- Cash-out refinance – A cash-out refinance allows you to refinance for more than you owe. This money is disbursed in cash and you can use it as you please. Let’s say you owe $220,000 on your mortgage. You can refinance for $250,000 and then take the extra $30,000 in cash. You will be required to repay the $250,000 in monthly installments, with interest.
- Home equity line of credit (HELOC) – This basically works like a credit card, only the credit limit is determined by your real estate property’s equity. For example, if you have $60,000 of equity, you could be eligible for a HELOC with an upper spending limit of $50,000. Just as with credit cards, you will be expected to pay back what you borrow.
- Home equity loans – This is equivalent to a second mortgage. If you have $80,000 in equity, you could get approved for a home equity loan of $60,000. The lender will offer you the loan in a single payment and you can spend it as you wish. You will pay back the home equity loan in monthly installments, with interest.
Before going for any of these financing options, consult a mortgage professional to understand the advantages and downsides of each.
3. Using equity for retirement
If you are a retired homeowner aged 62 or older, you could consider a reverse mortgage. Instead of making mortgage payments, you will be getting cash based on the equity in your property. Let’s say you have $150,000 of equity in your income property. You might just be eligible for a reverse mortgage of $100,000. You can choose to receive this cash in a line of credit, regular monthly payments, one lump sum or a combination of these three options.
Unlike other loans, reverse mortgages are only paid when the home is sold. The profits from the sale of your property will then be used to repay the loan. It’s also important to note that not all properties qualify for a reverse mortgage. If you’re a real estate investor, the only way to take advantage of a reverse mortgage is if you own a small multi family home (duplex, triplex, fourplex) and live in one of the units.
How to Build Equity
There are two main strategies for building equity in your investment property; reducing your debt and increasing your property value.
Reduce your debt
To build as much equity as possible in a short duration, find ways to reduce your debt quickly. The more your debt decreases, the higher your equity rises.
Here are some suggestions for lowering your debt:
- Choose shorter terms – You can pay off your mortgage faster and build more equity with short-term loans than long-term loans. Therefore, when it comes to building equity, it could be wiser to go for a 15-year investment property financing option rather than a 30-year mortgage.
- Make a large down payment – If the minimum required down payment for a mortgage is 20%, you can aim at putting down 35%. This means that you will already have equity of 35% in your rental property investment from the onset.
- Make extra payments – There is no law stating that you can’t pay more than the amount dictated in your mortgage agreement. Every extra dollar you pay above the minimum required amount will help in lowering your debt and building equity. You can use windfalls such as tax refunds, gifts, and bonuses to pay off your loan faster.
Related: Why You Shouldn’t Put Less Than 20% Down Payment
Increase the property value
The real estate market value of your property investment is a very critical element in building equity. If your investment property value increases, you automatically have more equity. So, how can you boost your rental property’s value?
- Add a rentable unit – You could remodel spaces such as the basement or garage into an extra rental unit. The rental income generated can then be added to your current monthly mortgage payment in order to boost the equity in your real estate investment.
- Improve your curb appeal – Boosting your curb appeal can increase the value of your investment property significantly. This could include landscaping, replacing windows, a fresh paint job, replacing the garage door, and adding stone veneers and wood decks.
- Improve the indoors – You could extend the kitchen, add an extra bedroom, invest in energy-efficient appliances or add a new bathroom. Be sure to select improvements with the highest return on investment.
Anytime you make certain updates and improvements to your rental property, it will cost you a significant amount. Do your homework first and crunch the numbers using a rental property or Airbnb calculator to make sure it all adds up before you proceed.
Related: Increasing Your Property Value in the First Year 101
Conclusion
Real estate naturally rises in value over time (appreciation). Therefore, the key to building equity in your investment property is patience. As you pay off your debt and make home improvements, allow time to take its course. Don’t be in a rush to cash in on the equity in your single family homes, condos or multi family homes.
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