Understanding home equity
When you take the current market value of your home that you receive after an appraisal and subtract it from the amount you currently owe on your mortgage, that’s your home’s equity. Your home equity is how much of the property that you truly own. This is the formula you will use to answer the question, “How much equity is in my home?” Knowing the amount of equity you have in your home plays a vital role in major decisions like taking out a loan for repairs, improvements or to purchase a new home.
How much equity do I have in my house?
To determine the amount of equity you have in your home, you need to have it appraised to get the market value. Once you have the home’s appraised value, you can figure out how much equity you have by subtracting that value from your current mortgage balance. Determining a home’s equity uses a simple formula:
The appraised value of the home – (minus) the mortgage balance = equity
For example, if your home appraises at $200,000 and your mortgage balance is $120,000, the formula for determining your equity would look like this:
$200,000 – $120,000 = $80,000In this scenario, there is $80,000 of available equity in the home.
What if my home value increases?
There are several reasons why your home-value increase is beneficial. If you need to borrow money for a renovation or addition to your home, an increase in value gives you more equity to do so. However, there are negatives to a value increase as well. If you’re refinancing and your appraisal comes in high, it can have a significant impact on your interest rate because lenders use the appraisal to determine the loan-to-value (LTV) ratio.
Can I have negative equity?
Negative equity in your home occurs if the value of your home is less than the total balance of your mortgage. Lenders reduce risks by ensuring that you aren’t borrowing more than 80% of your home’s total current value. If the housing market drops and your home’s value decreases, that could result in negative equity. In this scenario, if you want to sell your home, you’d have to pay the difference between what you owe and its selling price.
Understanding home equity with the loan-to-value formula
Financial institutions and other lenders use the loan-to-value ratio (LTV ratio) to assess your lending risk before approving a home equity loan. If the assessment is a high LTV ratio, that means it’s riskier and could cost the borrower more for the loan. For example, if the LTV is at least 80%, that means you’re more likely to secure favorable terms and lower interest rates. The formula for calculating LTV is:
Current loan balance ÷ Current appraised value = Answer x 100 = LTV
As an example, if your mortgage is $120,000, your LTV ratio calculation would look like this:
$120,000 ÷ $200,000 = 0.6 x 100 = 60%
Loan-to-value ratio and home equity loans
When you want to apply for a home equity loan, the loan-to-value ratio compares your home’s value to the amount of the home equity loan you’re trying to obtain. That means, if you’re currently carrying a mortgage balance, your loan balance serves as the basis for the LTV ratio.
An LTV ratio is important because it helps lenders determine if you qualify for refinancing. Lenders prefer seeing a low LTV to minimize risk. A high LTV ratio may indicate there aren’t enough assets to ensure your loan will be paid off.
An LTV calculation impacts your ability to get a home equity loan in many ways. For example, if it comes in too high, the loan appears riskier to lenders. If you default on the loan, the lender might have trouble recouping its loss when trying to sell the property. Other ways your LTV can affect you include:
- Better interest rates: If your LTV comes in low, you might get better interest rates on your home equity loan.
- Higher interest rates: There’s a potential for higher interest rates on your home equity loan when your LTV is high.
- Higher monthly payments: Your loan terms could change dramatically due to high interest rates which, in turn, can strain your finances.
How can I improve my home equity?
It isn’t uncommon for your home value to decrease over time due to changes in the market. However, if your home value remains stable, there are many ways to increase its equity. First, pay down your mortgage’s principal, which will lower your loan-to-value ratio. Next, consider paying more than the required minimum mortgage payment to reduce your LTV ratio. Here are some additional techniques to improve your home equity:
Tips for improving home equity
- Keep your home well maintained
- Invest in wise home improvements and upgrades (research the ones that will give you the most value)
- Enhance your home’s curb appeal
Frequently Asked Questions
How does home equity work?
As your mortgage balance decreases and your home value increases, you are building equity. In other words, home equity is the portion of your home that you own minus any outstanding debts.
How much equity do you need for a home equity loan?
Lenders require borrowers to have at least an 80% LTV ratio remaining after they receive a home equity loan approval. That means you must have at least 20% or more equity before going through the qualification process for a home equity loan.
What interest should I expect for a home equity loan?
Home equity loans have an annual percentage rate that lenders base on your credit history, income, home value, mortgage balance, loan terms and loan amount. If you have a home equity line of credit (HELOC), you’ll typically have a variable interest rate that is tied to the prime rate and is subject to change.
How long does it take to pay off a home equity loan?
Some home equity loan terms are as short as five years, while others can extend to between 10 and 15 years. The length of the loan also depends on whether or not you make extra payments.
Jenn Greenleaf is a professional writer from Maine who also works part-time as a bookkeeper for her husband’s residential construction business. She specializes in writing about HVAC, commercial construction and other home-related topics.