What You Need to Know about Mortgages and Equity

Housing thumbnailAh, springtime: when “for sale” signs start popping up with the daffodils and crocuses! Before you call your real estate agent, you might want to read up on some of the more technical aspects of homebuying—like exactly what homeownership can mean for your bottom line.

Mortgage basics

The majority of families that buy a home do so by taking out a loan—a mortgage—that covers at least some of the purchase price. Here are some words and phrases you might hear when shopping for a home loan:

  • Term: The duration of the loan. The most common term for home purchase loans is 30 years, but shorter-term loans also are available.
  • Down payment: A certain amount of money (usually a percentage of the purchase price) that borrowers must provide up front. Most mortgage lenders require this payment, which is applied to the purchase price of the home.
  • Interest rate: The cost of borrowing the money. Lenders charge borrowers a percentage of the mortgage amount in exchange for the loan. Borrowers with good credit can be eligible for lower rates. The rate can be fixed or adjustable, which means that it either stays the same throughout the loan term or changes at specified intervals.
  • Payment frequency and amount: How often you’ll make payments (generally monthly) and how much you pay. Fixed- and adjustable-rate mortgages generally have fully amortizing payment schedules—that is, the regularly scheduled payments will fully pay off the principal and interest over the loan term, with the amounts allocated to reducing principal and interest changing over time.

Figure 1: Example of the Allocation of Monthly Mortgage Payment to Interest and Principal, for a Selected 30-Year Fixed-Rate MortgageIn addition, homeowners can take advantage of tax deductions to help lower their taxable income; the recent tax law made some changes to these deductions. Homeowners who itemize deductions on their tax returns may deduct qualified interest they pay on their first and second mortgages of up to $750,000 for homes purchased after 12/15/2017 (for homes purchased on or before this date, taxpayers can deduct interest on the total mortgage, generally for debt up to $1 million). For taxable years beginning after 12/31/2025, homeowners may deduct interest on up to $1 million, regardless of when homeowners took on a mortgage. Relatedly, homeowners generally may deduct up to $10,000 for state and local taxes, including property taxes paid.

Trade-offs of building home equity more quickly

Home equity is the difference between the market value of a home and the amount owed on the mortgage. Home equity can be a way to build wealth, can be a cushion in times of hardship, and can also be used to pay for other things, like education. However, if a home’s market value falls and the homeowner owes more than their house is worth (or is “underwater”), home equity becomes negative.

The most common type of mortgage—the 30-year, fixed-rate—builds equity more slowly over time. There are ways to build equity more quickly, but there can be some trade-offs. For example:

  • Shorter loan terms: Homebuyers or homeowners refinancing their mortgages can choose a 15- or 20-year mortgage rather than a 30-year mortgage. These mortgages build equity more quickly and can also help the homeowner save on interest paid over the life of the loan. For example, for a $250,000 fixed-rate mortgage at 2017 interest rates, a homeowner would pay about $168,000 in interest for a 30-year mortgage, but only about $62,000 in interest for a 15-year mortgage. But shorter-term loans also require higher monthly mortgage payments—payments on a 15-year mortgage could be as much as 40% more than a 30-year mortgage, depending on the rates. That could mean that you wouldn’t be able to afford the same house you could with a 30-year mortgage.
  • Extra payments: Homeowners can make extra mortgage payments to further reduce the principal balance. For example, making an extra monthly payment of $100 on a 30-year fixed-rate mortgage of $225,000 would accelerate equity-building and reduce the mortgage term by more than 4 years.

Figure 2: Example of Home Equity Built over Time for a $225,000, 30-year Fixed-Rate Mortgage: Required Payment versus Additional $100 Payment Each Month

  • Refinancing: Homeowners can refinance their mortgages to take advantage of lower rates, shorter terms, or both, which can help build equity faster. When refinancing, some homeowners also can extract home equity as cash, but this reduces the amount of equity built. Refinance loans (similar to purchase loans) incur transaction costs, usually through fees (like tax recording and appraisal). Also, a homeowner who refinances to a lower interest rate could still pay more interest over the loan term if the refinancing extends the term past the prior mortgage’s.
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