What is home equity and why is it important to know how much it is? Learn how to calculate your home equity now. Read this article to know more
Calculating home equity may sound like a simple formula: Determine the market value estimation on your property and subtract your mortgage balance. The resulting number will be your home equity. But there is much more to home equity than that.
For starters, there are more ways than simply paying off your balance to build equity. And what about home equity loans? Is it the right move for you? Here is everything you need to know about calculating home equity, from how much you can borrow to when to avoid it.
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Home equity is essentially the difference between what your property is worth and what you still owe on the mortgage, i.e., the amount of your property that you have paid off. It is essentially your stake in your home, versus your lender’s. If you would like to use a formula to calculate your home equity, it would look like this:
Home value - loan balance = home equity.
Another easy way to think about it is if you owe $200,000 on your mortgage and your home is worth $250,000, you will have $50,000 of equity in your home.
There are two basic steps to calculating your home equity:
- Find out the market value estimate on your home.
- Subtract your mortgage balance.
Here is a closer look at each:
1. Find out the market value estimate on your home
Your home could be worth more or less today than when you purchased it. Because the housing market fluctuates the way it does, it is important to get a current estimate on the value of your home. While there are online home price estimator tools available to you, it may be a better idea to speak with a licensed appraiser or a local real estate agent to get a more accurate, up-to-date estimate.
2. Subtract your mortgage balance
After figuring out the market value of your property, you can then subtract the amount that you still owe on your mortgage, as well as other debts secured by your house. The number, based on that subtraction, is your home equity.
There are a few ways that you can build equity in your home:
- Make mortgage payments
- Make home improvements to add value to your home
- The value of the property increases
- Make a big down payment
Let’s take a more in-depth look at each of the ways you can build equity in your home.
Make mortgage payments
Making mortgage payments is perhaps the most straightforward way to increase equity in your home. Each month that you are making your mortgage payment, you are paying down the balance and building equity in your house. If you want to build equity even faster, and you have the funds to do so, you can make additional mortgage principal payments.
Make home improvements to add value to your home
If you make home improvements that increase that value of your property, you will increase your equity in the home, even if your mortgage principal balance stays the same. If you want to build equity in your home, you should keep in mind that some home improvements will add more value than others.
Make a big down payment
You can instantly increase your equity by making a big down payment when you purchase your property. If you can afford to, think about paying 20% versus 10% for your down payment. This will let you tap into your equity more quickly.
The value of the property increases
While it is not always a sure thing, property values do tend to increase over time. This increase in value is called appreciation and it is yet another way that you can build equity in your home. Since rising property values depend on the wider economy, location, and other factors, it is difficult to know how long you will have to live in your home to see this happen. Researching the historical price data of properties in your area may, however, provide insight.
The short answer is that you can borrow up to 85% of the equity you own in your home.
Home equity loans and home equity lines of credit (HELOCs) use the equity you own in your house as collateral. This essentially means that lenders are therefore able to offer you competitive interest rates, often like those of first mortgages.
For this reason, there is an upper limit on the amount that you can borrow through one of these types of loans. Typically, the maximum amount that a bank or a credit union will offer you is between 80% and 85% of your combined loan-to-value ratio. (A combined loan-to-value ratio, or CLTV, is the difference between how much you want to borrow and the value of the house.)
A second lien
When you apply for a home equity loan, your bank will place a second lien on your property. The second lien will give your lender the rights to your property, as well as the first mortgage lien, if you cannot make your loan payments. The reason the second lien exists is it makes home equity loans less of a risk for lenders, especially if they have loaned you less than you have invested in your property.
Having said that, every lender has their own guidelines to decide how much money they can loan to you. However, the most critical determination a lender will make is which CLTV ratio it can offer.
Home equity loan example
Most banks or credit unions offer a maximum CLTV ratio of 80%. If the value of your property is $300,000, then the most you could borrow would be $240,000. If, however, you owe $150,000 on your first mortgage, you would have to subtract that from the total since the lender will not lend you money you have yet to earn. Since $150,000 subtracted from $240,000 is $90,000, that would be your maximum loan amount.
While it is important to understand this example, there are other factors that could determine your eligibility for a home equity loan, such as your credit score, income, employment history, and whether you take out a reverse mortgage. Those factors will dictate the interest rate you are offered on the loan, since a lower credit score, for instance, may signal to the bank that you are at a greater risk of defaulting.
Before determining if it is a good idea to take equity out of your house, it is important to first understand the risks involved. One major reason for this is that these types of loans are tied to your house.
Here are some of the reasons it is likely best to avoid a home equity loan:
- To free up much needed cashflow
- To purchase a vehicle
- To fund a vacation
- To pay for post-secondary education
- To repay other debts
- To invest in real estate
Here is a closer look at each:
You will usually want to avoid using the money from a home equity loan to help solve any day-to-day money issues you may be having. The obvious reason is that home equity loans still need to be paid back, and you could find yourself deeper in debt if you fail to keep up with the monthly repayments. If you do not have a structured plan to repay the loan, you will likely find this option worsens your cashflow problems.
2. To purchase a vehicle
It is generally a bad idea to use a home equity loan to buy a new vehicle, since by doing so you are essentially moving debt around and failing to address the cause of the financial issue(s)—which is usually bad spending habits.
3. To fund a vacation
If you are funding leisure activities such as vacations using a home equity loan, you are likely spending well beyond your means. Your debt issues will only worsen if you use it to fund your lifestyle.
4. To pay for post-secondary education
Once again, using a home equity loan to pay for your post-secondary education is too risky, even if it can be otherwise viewed as an intelligent investment overall. You do not need to risk your house to pay for post-secondary education, especially since there are usually other ways. Consider the alternatives if you are thinking about paying for tuition for yourself or someone in your family.
5. To repay other debts
Even though home equity loans offer lower interest rates than most other forms of debt, such as credit card debt, it does not necessarily make it a good idea, particularly if you borrow the maximum amount on your home equity loan. Doing so puts you at risk of becoming upside-down on your loan. Instead, uncover and address the reasons that you are in high-interest debt. Otherwise, you will be at risk of paying off your home equity loan on top of your credit card every month.
6. To invest in real estate
Investing in real estate is speculative for the most part and tend to fluctuate. While it is possible that your investment in real estate will be successful, it may still be difficult to recoup enough of your money to repay your home equity loan.
Calculating home equity may be a simple formula. But as we have seen, there are many complexities and considerations that need to be made when it comes to how much equity you can borrow and whether it is the best move for you, given your financial situation.
Have experience with calculating home equity? Let us know in the comment section below what you used this information for.