What is Home Equity?
What you'll learn: How to calculate the equity in your home and how home equity can work for you
EXPECTED READ TIME: 4 MINUTES
December 01, 2020
How do I know how much equity I have in my home?
Home equity is simply determined by looking at the current value of your home and subtracting what you owe on that home. What’s left is your home equity. To fully understand the current value of your home, you can use some online tools and even talk to a real estate agent to get a better understanding of your home’s value. If you decide to get a loan based on equity, the lender is likely to require a more formal process with an appraisal, which will confirm the actual current home value.
As an example, let’s assume you’ve been living in a home you purchased for $350,000. You do some research and understand the current market value to be approximately $425,000. In reviewing your outstanding debt on the home (inclusive of all loans like a second mortgage or even another home equity loan), you still owe $275,000. Your equity is calculated by taking the value, minus the debt ($425,000 - $275,000 = $150,000).
What is LTV?
LTV stands for loan-to-value. This is a ratio used to determine how much you can borrow. For a home equity loan, most lenders will look for an LTV ratio that is no more than 80–85% of the total value. Continuing with our example above, a lender may look at your home value of $425,000 and use an 80% LTV ($425,000 x .8 = $340,000). The next step in determining how much you can borrow is to subtract what you still owe on the home ($275,000) to determine what you may qualify for with a home equity loan ($425,000 X .8 = $340,000.00 - $275,000 = $65,000).
How can I increase the equity in my home?
There are a few ways you can build equity in your home. The first and most obvious is to make regular mortgage payments on time. Over time, you will have paid enough principal so that you have increased your equity. This does take a considerable amount of time, of course.
Your home’s equity also increases is its value goes up. This could be due to market forces such as a strong economy or even too few available houses on the market, which may cause prices to increase because of supply and demand.
One great way to increase the equity in your home is to upgrade areas of your home that may increase its value. Oftentimes, upgrades to the kitchen or bathrooms can increase a home’s value. Other ways to increase your home’s value include upgrading the home’s curb appeal through landscaping and keeping excellent care of all the systems, such as the heating and cooling systems.
What are home equity loans?
There are really two types of loans that can leverage the equity in your home. The first is a home equity loan. With this type of loan, you apply for the loan and if approved, you receive the funds all at once. This is a fixed interest type of loan that uses your home as collateral.
Another type of home equity loan is called a home equity line of credit (HELOC). With this type of loan, you leverage the equity from your home as you need it. It’s not delivered to you all at once up front and therefore you can pull as little or as much as you need, when you need it. The interest rate is generally variable and is based on current market rates, but the advantage is that you are only paying interest on the funds that you are withdrawing and not a larger lump sum. Although these loans are similar, it is important to understand the difference between a home equity loan and a HELOC.
How does a home equity loan work?
Once you’ve determined your home equity through the process above, you can apply for a home equity loan or HELOC. Typically, you’ll need the following to qualify:
- A good credit score — as usual, the stronger your credit score the better.
- An LTV of less than 80–85%, as outlined above.
- An acceptable DTI — debt to income ratio. You can calculate your DTI by adding all your monthly debt payments, such as credit cards and car payments, and dividing the total by your gross monthly income.
- A proven and documented way to repay the loan.
There are many ways you can leverage the equity in your home. Often the best way to use the equity in your home is to further increase the home’s value through upgrades, That may be a new kitchen, or energy efficient windows or appliances. Some examples of how you can leverage the equity in your home include:
- Home upgrades
- Debt consolidation
- Paying off student loans
- Planning for future education
- Emergency expenses
As with anything, there are pros and cons of equity loans. You should also understand that leveraging the equity in your home is using your home as collateral for a new debt. You will need to determine your needs and whether this is a good move for you financially.
To learn more about HELOCs or home equity loans, contact PenFed:the Mortgage Center