Everyone hates to throw away money, and it feels like you are when you pay rent each month, but how much home equity are you actually building when you buy a house? Jessica and James are a young couple in their mid-20s. They have always rented while living in downtown St Louis, Missouri. Their parents strongly advised them to buy a house as quickly as possible, so they weren’t ‘throwing money away’ on rent.
Jessica and James prefer apartment living. They love the freedom it provides. There is no need to worry about mowing the lawn or shoveling snow, but they are ready to do the ‘adult’ thing and buy a house if it is a financially sound move.
The couple must consider their down payment, credit score, debt-to-income ratio, and monthly home maintenance expenses when determining how much they can spend on a home. They both have good, stable jobs and tend to be savers. Financially, they are in a good position to buy their home.
Home buying terms
Down payments: The amount you have saved to put towards the purchase price of your home. If you cannot put 20% down, you may be required to obtain private mortgage insurance (PMI) to protect the lender in case you cannot pay your monthly payments.
Credit score: Your credit score, frequently called a FICO score, is calculated based on information reported by the three major credit bureaus: TransUnion, Equifax, and Experian. Each of the three credit bureaus derives a score ranging from 350 to 850. Typically, if you have a higher credit score, you may qualify for a lower interest rate.
Debt to Income Ratio: This is the ratio of your monthly debt to monthly income reported as a percentage. Add up all your debt and divide it by your monthly income. The lower the debt to income ratio, the more you may be able to borrow for your new home.
Monthly maintenance: All the expenses you must pay to maintain your home, including property taxes, homeowner’s insurance, utilities, association fees, and property upkeep expenses.
What is home equity?
Home equity refers to the percentage of your home’s value that is actually yours. The rest of the equity belongs to your lender. Unless, of course, you have already paid off your mortgage. Every time you make a mortgage payment, a percentage of that payment goes toward equity, and the rest goes toward the interest you are paying on the loan. As you build equity, you may be able to use it as collateral and borrow against its value.
How much home equity are you actually building?
You can use this calculator from HSH to answer that question. Jessica and James have $120,000 for a down payment. They want to put at least 20% down on their home to avoid paying private mortgage insurance. The couple has also allocated 5% of the home value to cover attorney fees, appraisal fees, mortgage recording fees, transfer taxes, and title insurance premiums.
Jessica and James are looking at a home that is listed for $575,000. They were approved for a 30-year mortgage with a 4.25% interest rate.
Let’s assume that Jessica and James bought that house and have lived in it for the last seven years. How much equity do they have? Let’s also assume the housing market is relatively flat. Their home is currently worth $600,000 in today’s market.
Purchase Price: $575,000
Down payment: $120,000
Loan Amount: $455,000
Current Home Value: $600,000
Original Equity: $120,000
Current Equity: $217,405
Equity Gained: $86,202
Interest Paid: $128,211
Over the past seven years, an average amount of time in a home, they have paid $128,211 in interest and gained $86,202 in equity. At the end of the 30-year mortgage, they will have made 360 payments that total $805,797.54 with a total interest paid of $350,797.54.
When they sell the home, they will pay the realtor’s fees and closing costs. Of course, these calculations do not consider the money they might have spent on home improvements, property taxes, homeowner’s insurance, and upkeep.
After adding these additional expenses to their interest paid and subtracting the equity they gained, Jessica and James will be able to calculate how much money they spent to “rent” their home to themselves over the past seven years.
The numbers will continue to improve if Jessica and James stay in their current residence. As their loan matures, their monthly payment will pay a higher percentage towards the principal and a lower percentage towards the interest.
They may also refinance at some point and get a lower interest rate.
Jessica and James can consult with their wealth advisor to discuss their home-buying plans. Purchasing a home is a major financial investment that necessitates careful planning and goal prioritization. Based on current interest rates, monthly payments, and the down payment they can afford, the price range of homes they are interested in, and the length of time they intend to stay in a home, they can create a plan that will meet their life goals—both personal and financial.
