This article was written by Christy Rakoczy and is courtesy of LendEDU
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Home equity is the difference between the value of your home and the current outstanding mortgage debt. Calculating your home equity is as easy as figuring out what your home is worth and subtracting the existing liens on the property (including a home equity loan or home equity line of credit) from that total.
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Most homeowners have a mortgage, which means they don’t actually own their home — at least not all of it. However, when you provide a down payment at the time of purchase, make your monthly mortgage payments, or your home rises in value compared to what you owe, you acquire some value in your home that doesn’t belong to the bank. That’s your home equity.
Knowing how much equity you have in your home can provide insight into your net worth. It also lets you estimate how much profit you’d be left with if you sold your home and how much money you could access by taking out a home equity loan or a home equity line of credit (HELOC).
This guide will show you exactly how to calculate your home equity and why it’s important.
In this guide:
How to Calculate Your Home EquityIf you own your home free and clear, your home equity is easy to calculate. It’s equal to the total appraised value of your home. You own the entire house and the bank owns none of it. But if you have one or more mortgages or other liens against your home, your equity is equal to the current appraised value of your home minus the remaining balance on your loans.
When doing this calculation, it’s important to note the current appraised value of your home is likely different from the amount you originally paid. If property values have been rising in your area, the appraised value could actually be much higher — but if property values have fallen, the appraised value may be lower. This was common during the 2008 financial crisis when real estate values tumbled.
>> Read more: Home Equity Loan Calculator
For example, if you owe $200,000 on your mortgage but your home’s appraised value is just $175,000, you’d actually have negative equity of $25,000.
It’s also important to realize the equity you have grows with each mortgage payment you make. It increases based on the amount of principal you pay down — the interest portion of your payment goes directly to your lender as part of the cost of borrowing, so it doesn’t actually reduce your outstanding balance.
However, it’s not enough to know how to calculate the equity in your home. You should also learn how to calculate your loan-to-value ratio.
How to Calculate Your Loan-to-Value Ratio
Your loan-to-value ratio shows the percentage of your home’s total value that you still owe. You need to know this because lenders consider your loan-to-value ratio when deciding what kinds of loans — such as mortgages, home equity loans, and home equity lines of credit — you might be eligible for.
Your loan-to-value ratio also determines the interest rate you’d pay if you borrowed against the equity in your home, as well as whether you’ll need to pay for private mortgage insurance, which protects the lender in the event you default on your loan.
To calculate your loan-to-value ratio, you’ll divide your current loan balance by the current appraised value of your home. For example, if you owe $140,000 on a $250,000 home, you’d divide $140,000 by $250,000 to get a loan-to-value ratio of .56. Loan-to-value ratios are usually expressed as a percentage, so multiply this number by 100 to get your LTV ratio of 56%.
How to Tell If You Qualify for a Home Equity Loan or HELOC
Both home equity loans and home equity lines of credit are a source of affordable financing based on your property’s assessed value. To qualify for either type of financing, you’ll need to have:
>> Read More: Home Equity Loan and HELOC Requirements
Should I Choose a Home Equity Loan or HELOC?
Although home equity loans and HELOCs both let you tap into home equity, they work a bit differently. A home equity loan allows you to borrow a set amount of money upfront. The loan has either a fixed or variable interest rate and is repaid over a specified time period. A HELOC, on the other hand, gives you a line of credit. This means you can borrow as much or as little as you need at any given time, up to your total approved credit line. Usually, HELOCs come with variable interest rates.
Think about the pros and cons of home equity loans vs. HELOCs before deciding which one is better for you. You might also consider a second mortgage or cash-out refinance as another source of funding.
Before taking out any of these loans, though, you should be aware you’re taking a big risk. If you become unable to repay the lender, your risk losing your home to foreclosure. If home prices fall and you end up owing more than your house is worth, selling could also become impossible unless you have enough cash to pay the difference between what you can sell your home for and what you owe — or unless you’re willing to ruin your credit and get your lender to agree to a short sale.
These risks may be worth it because of the lower interest rates associated with these loans, especially compared to credit cards and personal loans. If you’re using the loan to pay down existing high-interest debt or to pay for home improvements, you may decide that borrowing against your home equity makes sense.
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