Mortgage

Many people are still confused about home equity, even though it’s a widely-discussed topic nowadays. As a homeowner, you need to understand how home equity works — especially if you’re looking into refinancing your mortgage or borrowing money from your residence.

Home equity is the difference between the appraised value of your house and the amount you owe on your mortgage. The amount of equity in your property has many ramifications for your finances, from whether or not you require private mortgage insurance to what financing alternatives are accessible to you. The value of your home equity can go up or down depending on market conditions in your area. Here’s a quick guide to help you calculate how much equity you have and some tips for increasing it.

Key Takeaways

  • The difference between the current value of your house and its outstanding mortgage is known as home equity.
  • Lenders will usually not allow you to borrow against the total value of your home equity.
  • Under average economic conditions, you could potentially borrow up to 90% of your equity.
  • During the 2020 financial crisis, lenders restricted access to home equity and raised credit score requirements, particularly for HELOCs.

How Much Home Equity Do You Have?

The difference between the current market value of your property and the total amount of debts (particularly your primary mortgage) recorded against it is known as your home equity value.

The current equity determines the amount of credit you can access as a borrower through a home equity loan. Let’s say your house is valued at $250,000, and you still owe $150,000 on your mortgage. If we subtract what you owe from the home’s total value, that leaves us with $100,000 in home equity.

How Big a Home Equity Loan Can You Get?

Only some lenders will let you take out a loan for the total value of your home equity. They usually allow loans worth 80% to 90% of available equity based on the lender, credit score, and income. So, if you have $100,000 in home equity, as seen in the example above, you could qualify for a HELOC of $80,000 to $90,000.

Here’s another scenario that incorporates a few more elements. Assume you have a 30-year mortgage on your home and are five years into it. Furthermore, a recent appraisal or assessment valued your property at $250,000. You also still have $195,000 outstanding on the original $200,000 loan. Keep in mind that the vast majority of your early house mortgage payments go toward reducing the principal balance.

If no other obligations are tied to the house, you have $55,000 in home equity. That equals the $250,000 current market value minus the $195,000 debt. You can also divide home equity by the market value to determine your home equity percentage. In this case, the home equity percentage is 22% ($55,000 ÷ $250,000 = 0.22).

Suppose you also took out a $40,000 home equity loan in addition to your mortgage. The total indebtedness on the property is $235,000 instead of $195,000. That changes your total equity to just $15,000, dropping your home equity percentage to 6%.

Start With a Baseline Calculation

To calculate how much equity you have in your home, subtract the amount of all loans attached to your house from its appraised value. This would include primary mortgages, home equity loans, or any unpaid balances on a home equity line of credit. For example, homeowner Caroline owes $140,000 on a mortgage for her recently appraised property at $400,000.

Next, Take a Look At How Banks Calculate Equity

Mortgage, refinancing, and home equity lenders may utilize different methods to determine how much they’re willing to lend you and whether or not they’ll even offer you a loan. The loan-to-value (LTV) ratio is one of the metrics they look at. If you have a mortgage, your LTV ratio is determined by your outstanding loan balance. If you don’t have a mortgage, the LTV ratio is calculated based on the amount of money borrowed against the value of your property. The LTV ratio is essential when determining whether or not you qualify for a mortgage refinance. 

Private mortgage insurance might be required if your LTV ratio is too large. A professional appraisal is needed to correctly calculate your LTV ratio. That’s why your lender frequently wants an on-site appraisal during the loan application process. To determine your LTV ratio, divide your present debt (found on your monthly statement or online account) by the assessed value of your home (you can find this number on the official records). Convert this figure to a percentage by multiplying it by 100. Caroline’s loan-to-value ratio is 35%.

Possible Effects on Insurance

Pay close attention to your LTV ratio if you have private mortgage insurance (PMI). If a home’s LTV ratio falls below 78%, federal law requires lenders to cancel the PMI. This is typically done when the loan balance reaches that percentage, but if extra payments cause the LTV ratio to drop below 80%, policyholders can request the cancellation of their PMI.

What About Home Equity Loans?

What About Home Equity Loans?

Another critical calculation to make is your combined loan-to-value (CLTV) ratio, which compares the value of your house with the total of all the loans secured by it, including the loan or line of credit you’re looking for. If Caroline wants to acquire a $75,000 home equity line of credit, she will calculate her CLTV ratio. She will likely be prepared if most lenders demand a CLTV ratio below 85% to qualify for a home equity line of credit.

Ways to Potentially Increase Your Equity

One way to reduce your loan-to-value ratio is by paying extra on your mortgage principal each month. This will help reduce the balance of your loan quickly. Check if there are any penalties for prepaying first, though some loans don’t have this problem.

An excellent approach for protecting your home’s value is to keep it clean and maintained. A messy, unkempt home is a waste of money. It looks unprofessional and can also make you liable for costly cleanup costs, especially if you have water leaks or have had floods on your property. Also, be sure to regularly check for mold. Remember that not all mold is the same; some types are more hazardous than others.

If you believe your house’s value has slipped below the purchase price, try removing unnecessary items to increase its appeal before selling it. Do any necessary home improvements. 

However, be sure to contact an appraiser or real estate professional before making any improvements if you hope will raise the sale price of your house. Remember that economic conditions — as well as the regular dips in the real estate market — might impact your house’s value no matter what you do. If home prices rise, your LTV ratio could go down; however, falling home prices may negate any improvements made to them.

Read More: Is 2022 A Good Time To Buy A Home?

Transaction Costs

Because real estate is one of the most illiquid assets, there is generally an additional cost associated with using your home equity. The overall closing costs are usually between 2% and 5% in the United States. Buyers frequently cover a large portion of these fees but keep in mind that they might use them as a pretext to negotiate a lower sale price. If you take out a home equity loan, factors such as an origination fee and higher interest rates will reduce the amount of home equity available.

The Loan-To-Value Ratio

The loan-to-value ratio (LTV) is another way to express equity in your home. You calculate the remaining loan balance by the current market value. In the second example described above, your LTV would be 78%. Including your $40,000 home equity loan would make the total 94%.

Lenders dislike high LTVs since it indicates that you may be unable to repay your loans and might tighten their lending standards during economic turmoil. That was the case with the 2020 recession. Banks increased credit score requirements for HELOCs, lowering dollar amounts and the percentage of home equity they were willing to lend.

LTV and home equity values are vulnerable to fluctuations in the market price of a house. Hundreds of millions of dollars in purported home equity were destroyed during the subprime mortgage crisis of 2007–2008, and the long-term effect of 2020 on homeownership is still unknown.

Indeed, worldwide house prices rose through 2021 as a result of the stay-at-home policy and individuals searching for bigger homes to accommodate their career, education, and family life. In addition, the increasing number of companies offering work-from-home policies incentivized many families to move from cities to suburbs. Overall, we are at a historic moment regarding the pandemic and its impact on homes. It’s yet unclear what the future holds.

Read More: What Type Of Mortgage Program Is Best For You?

How Loan-To-Value Ratio May Affect Your Loans

The loan-to-value (LTV) ratio is one way that lenders may choose to finance or deny a loan. This equation compares the amount of money you’re asking for in a loan to the home’s value. If you already have a mortgage, your LTV ratio will be based on how much you still owe. The LTV ratio can affect whether private mortgage insurance (PMI) is required and if refinancing might be an option.

To calculate your LTV ratio, divide your current mortgage amount by the appraised value of your home. To convert it to a percentage, multiply that number by 100.

How To Cancel Private Mortgage Insurance

If you purchased your home with less than a 20% down payment, your lender probably required you to get PMI. However, it’s only required if your house LTV ratio is above a certain point. The Homeowners Protection Act requires lenders to automatically cancel PMI when a home’s LTV falls below 78% — as long as other requirements are met.

Your loan is automatically canceled when the balance reaches 78% of your home’s appraised value. If, however, you have made extra payments and your LTV drops below 80% before that time, you can request that your lender cancel PMI.

How to Account for a Home Equity Line of Credit

Another factor to consider when taking out a home equity loan or line of credit is your combined loan-to-value ratio (CLTV). This compares the value of your home to the amount of all loans secured by it, including the one you’re requesting.

To qualify for a home equity loan or line of credit, your total CLTV must be less than 85% (though this number may be higher or vary from lender to lender). On the other hand, your property’s value may swing up and down over time, so if the value drops, you might not qualify for a home equity loan or line of credit, or you could end up owing more than the current market value of your house.

The Bottom Line

If you have enough equity in your house and can afford to repay the loan, using a home equity loan to pay for a significant home renovation or to consolidate debt may be a good idea. Because they rely on your house as collateral, home equity loans generally have lower rates than other choices. To do so, first, see if you qualify and get an estimate of your interest rates.

Do you have any questions about home equity?  Leave a comment below or contact us for a free consultation.

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