On the surface, home equity is essentially the market value of a homeowner’s unencumbered interest in their respective property. Beneath the surface, however, home equity is an invaluable tool that can simultaneously help homeowners build wealth and fund future investments in their home, family and debt obligations. If for nothing else, home equity is an alternative source of capital that, when used wisely, can benefit homeowners immensely.
Home equity grants owners access to relatively affordable funding. However, tapping into equity in one’s home is not something that should be taken lightly. Much like every other financial source, using home equity coincides with both pros and cons. As a result, homeowners need to know how to calculate home equity and how to navigate its tricky waters.
What Is Home Equity?
Home equity represents the difference between your current home value and your mortgage loan balance. More specifically, however, home equity is the overall value of a homeowner’s unencumbered interest in a subject property. Therefore, if a home is worth more than the current mortgage taken out on it, the owner’s interest in the home may be included in their net worth.
For instance, let’s say a home is currently valued at $800,000, and the owner owes $400,000 on the mortgage. The owner’s home equity in this scenario is $400,000. It is important to note that home equity valuations are subject to changes based on mortgage payments and property value.
To be clear, the unencumbered interest in a property isn’t always positive. In the event a homeowner owes more on the mortgage than the home is worth, they are considered “under water.” The homeowner still owns the interest in the property, but the negative net worth becomes a liability instead of a benefit.
How Does Home Equity Work?
Home equity represents the financial stake an owner has in their house. Consequently, borrowers who took out a loan to buy their home do not own the property outright, so there are varying degrees of ownership interest. Those who still owe money to the bank will have less interest in the property than those who have paid back their loan.
The goal is to eventually attain 100 percent equity in a house. That said, there are two ways homeowners can increase their equity. The first is to pay down the mortgage, and the second occurs when home values increase. Changes in your value could be caused by market conditions outside of the owners control, but there’s always the option of increasing home values through upgrades. Increasing the value of a home through improvements can increase equity, oftentimes faster than market increases.
Again, home values don’t always increase, and that’s an important realization owners need to familiarize themselves with. If a home value decreases at a faster rate than the owner can pay down the mortgage, their equity will take a hit. Unfortunately, real estate market conditions fluctuate and are hard to predict. Nonetheless, homeowners can put their best foot forward by buying in a strong location and focusing on what they can control.
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How Much Home Equity Do I Have?
How much equity do you have in your home? An example of how a hypothetical homeowner would calculate their home equity will help illustrate how you can calculate your own home equity.
Pulling from our home equity definition earlier, let’s say an aspiring homeowner purchased their $800,000 house with a 10% down payment. With a mortgage balance of $720,000, the owner’s home equity is $80,000 (home value minus mortgage balance). Over the next two years, $8,000 of the owner’s mortgage payments are applied to the principal. If the home value remained the same, they would have accumulated $88,000 in home equity (home value minus current mortgage balance). Let’s say, for the sake of this home equity example, the owner’s home value increased by $100,000 over these two years. The owner’s equity would be $188,000 (increased home value minus current mortgage balance).
To calculate how much equity you have in your own home, simply divide your current mortgage balance by your home’s market value. In doing so, you will identify how much equity you have in your home, expressed as a percentage.
How Much Can I Borrow From Home Equity?
Although it varies by lender, homeowners can typically borrow anywhere from 75% to 90% of their available equity.
Let’s say, for example, the owner’s mortgage lender allows them to borrow up to 80%. Expressed as a percentage gives borrowers a good idea of how much they can borrow, but it may be more helpful when the equity is expressed as a dollar amount. To find out exactly how much cash you can borrow from home equity, use the following equation:
To be clear, just because homeowners can borrow against their home’s equity doesn’t automatically mean they should. If for nothing else, there are other important variables to consider. Most notably, prospective borrowers should look into two important indicators:
The costs incurred from tapping into a home’s equity need to be factored into any decision of whether or not to withdraw capital. At the very least, the illiquid nature of real estate places a premium price on the act of accessing equity within a home. One of the ways to tap into the equity, for example, involves selling the home. In the event the owner sells the house, the equity would represent the profit they made from the original purchase. However, selling a home isn’t cheap. Transaction costs can amount to thousands of dollars and include everything from closing costs to Realtor fees. To be fair, buyers usually pay closing costs, but that doesn’t mean they can’t use them as a negotiation chip.
One way to decide if a homeowner should or shouldn’t borrow from their equity is to calculate the loan-to-value (LTV) ratio. The LTV ratio is an important metric used by lenders to accept or reject loan applications. As its name suggests, the LTV ratio expresses the ratio of a loan to the value of an asset purchased.
To calculate your LTV ratio, simply divide your mortgage balance by your current home value. Follow this example to calculate your own LTV ratio:
For some perspective, most lenders require an LTV ratio somewhere in the neighborhood of 85% or less. Therefore, homeowners above this benchmark may not be able to tap into their equity; that, or they will need to either benefit from appreciation or pay down their debt in order to qualify.
How To Build & Increase Home Equity
The equitable interest someone holds in a property can be increased several ways, not the least of which include:
Increase The Down Payment: Arguably one of the fastest ways to build equity in a home, increasing the initial down payment increase equitable interest in a property immediately. The larger the down payment, the more instant equity a buyer has in a home.
Make Larger Monthly Payments: If funds are limited at the time of purchase, homeowners may contribute more to monthly payments in order to tip the LTV ratio in their favor faster.
Pay Off The Mortgage: While not everyone has the luxury of doing so, paying off the mortgage completely will give homeowners 100% equitable interest in a home.
Live In The Home Longer Than 5 Years: While not guaranteed, history has taught us that homes appreciate more often than they depreciate. Therefore, the longer someone owns a home, the more likely they are to increase their equity in it.
Renovate & Improve The Home: Renovating and improving an existing home can increase its value, and inevitably the owner’s equity. It is worth noting, however, that the cost of the renovations will detract from the equity gained.
How To Borrow From Your Home Equity
So far, we have demonstrated how to calculate home equity, LTV ratios, and how much borrower’s may be able to take out. Next, it is time to understand how to leverage home equity. Borrowers who decide to use home equity have two primary options:
Home Equity Line Of Credit (HELOC)
Home Equity Loan
A home equity line of credit, or HELOC for short, operates similarly to a credit card. Homeowners use their home equity to open a line of credit, which typically lasts up to 10 years. HELOCs are flexible in nature, and borrowers get to choose what projects they want to fund. Simply put, homeowners borrow what they need, pay it down, and then borrow more. Once the borrowing period ends, any remaining balance converts to a loan that must be repaid over a set number of years. HELOC interest rates are variable and can change over time.
Home Equity Loan
A home equity loan allows you to borrow a lump sum of funds against your home equity. You would be responsible for repaying the loan in installments, plus a fixed interest rate. The benefits of home equity loans include, but are not limited to:
Predictable: Because of the fixed interest rate, borrowers will have the same monthly payment until the loan is paid off.
Low rates: Home equity loan rates are lower relative to credit card interest rates or other types of loans, making home equity loans more affordable to borrow.
Long repayment terms: Home equity loans offer repayment terms that can last from anywhere between 5 and 30 years.
Requirements To Borrow From Home Equity
Before applying for a home equity loan or HELOC, borrowers need to get approved. Regardless of which option you prefer, the requirements are typically the same:
Built some equity in their home
A low debt-to-income ratio
Stellar payment history
Requirement specifications vary by lender, but the list above should give borrowers a preliminary idea of whether or not you’d make a good candidate. If you need some help improving your financial circumstances, check out our guide on real estate financing tips to improve your credit score.
Homeowners who have built up equity in their home have access to favorable loan options. Both HELOCs and home equity loans tend to be more affordable to repay than other forms of high-interest debt like credit cards. Therefore, it may literally pay to learn how to calculate home equity. Those who are able to calculate the equity they have in their homes may be able to tap into it and borrow at an affordable rate. To that end, borrowers must understand that these loans use the home as collateral. Borrowers should only pursue these options if they can justify borrowing against their equity and have a solid repayment plan.
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