Home equity sheds light on how much of your home you own, and as this number grows, a homeowner gets closer to repaying the mortgage. This number also helps you calculate how much you can take out as a home equity line of credit. Real estate investors often use home equity credit lines to invest in additional assets. A homeowner may also use this credit line to cover home improvements, vacations, or other expenses. We’ll share how to calculate home equity and some ways to access these funds.
What is Home Equity?
Home equity reveals how much of your home you own. Each mortgage payment is an investment that builds up your equity. Home equity also increases when your property’s value goes up. Rising property prices don’t impact the remaining balance on your mortgage, but they help when it’s time to sell or if you want more financing. If you don’t borrow against your home, equity will continue to build and get closer to 100% with every monthly payment, but some people benefit from using that credit line.
How Do You Calculate Your Home Equity?
Many homeowners want to know their home equity. It can guide financial decisions and provides clarity on their current position. Follow these steps to calculate your equity.
Determine Your Home’s Value
Your home’s value, determined by an appraiser’s assessment, indicates your highest possible equity. Your home equity cannot exceed the value of your home. If it’s been a while since someone appraised your property, this tactic can increase your home’s value.
Deduct the Amount You Owe
Knowing how much equity you have in your home can help with your exit strategy or deciding how much to ask for in a second mortgage. Many homeowners have obligations such as a mortgage on their homes. When you deduct these debts from your home’s value, you will arrive at your home equity position. For example, if your home is appraised at $800,000 and you have a $500,000 mortgage balance, you have $300,000 equity in your home. Staying up to date on mortgage payments will increase your equity.
Calculate Your Loan-to-Value Ratio
Your loan-to-value ratio impacts your financing options, and all lenders have maximum loan-to-value (LTV) ratios. Lenders may require you to pay private mortgage insurance if your loan-to-value ratio exceeds 80%. They may also turn you down for a HELOC if your loan-to-value ratio is close to 80%.
If you want to calculate your LTV ratio, you’ll need total obligations on your home and the appraised value. For example, if you owe $400,000 and your home is worth $500,000, your loan-to-value ratio is 80%. Reducing this ratio over time makes your application more attractive to lenders. Not only will you increase your approval chances, but you’ll likely score a lower interest rate too. A rule of thumb is that the less risk a lender incurs for giving capital to a borrower, the lower the interest rate.
What is Your Credit Score and Annual Income?
You don’t need to use your credit score or annual income to calculate your home equity. However, they impact your ability to get a home equity line of credit or loan. They also use this information to determine what terms and rates you should get.
Credit score and annual income help lenders assess your financial health and ability to stay on top of loan payments. Borrowers with credit scores above 700 are desirable for banks, credit unions, and online lenders. These borrowers have demonstrated trustworthiness across several debts. If their income is also sufficient, these borrowers can expect to get the lowest interest rates and higher loan amounts.
However, borrowers who barely make the cut with a credit score in the low 600s may face higher interest rates and lower loan amounts. That’s especially true if they don’t have a high enough annual income. Instead of setting an income benchmark, lenders assess applicants based on a debt-to-income ratio. This ratio measures your debt against your income, and a higher percentage suggests more difficulty with managing a new payment.
For instance, if you earn $5,000 per month and pay $2,000 per month in debt, you have a 40% debt-to-income ratio. Not all banks may accept that, and DTI requirements differ across financial institutions. You can only lower your debt-to-income ratio by earning more money, paying off debt faster, or refinancing existing debt in a way that adds more years and reduces the monthly payments. While these numbers do not impact your home equity, they influence how much of it you can access. Making extra payments on other financial obligations leading up to a HELOC application can improve your changes and help you secure more capital.
How Do I Access Home Equity?
Accessing home equity helps people pay high costs. You can keep up with the cost of living, pay for a car, or cover medical bills. Not every homeowner plans to access home equity, but doing so may become necessary in the future. We’ll share some financing options that let you tap into your home equity.
Get a Home Equity Loan
A home equity loan is a lump-sum payment from your lender. You must then make fixed monthly payments to pay back the loan, which starts upon receiving the capital. You have to approach a lender each time you want to take out additional funds.
Your lender will review your income, credit score, and other documents before handing out a loan. Lenders will set a limit on your loan-to-value ratio. Some lenders don’t let you exceed an 80% loan-to-value ratio, but a few lenders let their borrowers stretch beyond the 80% threshold.
Home Equity Line of Credit (HELOC)
A HELOC is similar to a home equity loan. However, instead of approaching the lender each time, you can take out funds whenever you need them. In that regard, home equity lines of credit are similar to credit cards. However, HELOCs feature lower interest rates because they are tied to collateral. Since most credit cards are unsecured and the secured ones usually go to people with lower credit scores, they feature higher interest rates.
Lenders will ask for the same financial details for HELOCs and home equity loans, such as your credit score and annual income. A HELOC gives you more flexibility than a home equity loan. You have more access to your equity, and you’re not obligated to borrow money against your home. Not borrowing against your home means no interest payments. You can spend less than planned and save money.
HELOCs tend to have variable interest rates, while home equity loans have fixed interest rates. Variable rates make monthly payments less predictable because interest rates influence how much you have to pay. On the other hand, fixed-interest rate loans have predictable monthly payments that you can anticipate in your budgeting without having to worry about any surprises.
A cash-out refinance replaces an old mortgage with a new one. The new mortgage pays off the old mortgage and becomes the new financing arrangement for your home. Refinancing is popular among homeowners and can be a good idea if you need any of these benefits:
- You get extra cash at the moment. Increasing your mortgage leads to a windfall of funds, similar to a home equity loan. You can also capitalize on your property’s rising market value to borrow more money. Most lenders have an 80% loan-to-value maximum, and appreciation allows you to borrow a higher amount of equity while staying under that maximum.
- A refinance reduces monthly payments. Turning a 10-year mortgage into a 15-year mortgage increases payment periods. Longer terms spread the same principal across more intervals and lower monthly payments in the process.
- Capitalize on interest rate fluctuations. Some homeowners purchase their properties during periods of high-interest rates. Rates can decline after you purchase your home, but fixed-rate loans don’t get any cheaper. Refinancing helps you pay at the current rate instead of your existing mortgage’s interest rate. A lower interest rate will make monthly mortgage payments more affordable.
Lenders will assess financial documents to gauge your ability to manage extra debt. A cash-out refinance is the only option that lets you borrow beyond your home’s equity. Some lenders allow you to borrow enough money to reach a 125% loan-to-value ratio.
If your home is worth $500,000 and you currently owe $400,000, some lenders will let you borrow $225,000 for a cash-out refinance. This arrangement would push your total obligations to $625,000. Therefore, your obligations in this example are 25% higher than the home’s $500,000 appraised value. However, if you sell your home while it has a loan-to-value ratio above 100%, you will have to pay off the entire loan with your home’s equity and outside cash that covers the difference. It’s possible that you make enough mortgage payments and see some appreciation before selling that would take your loan-to-value ratio below 100% again.
HELOC and home equity loan lenders are different because they won’t consider your application if you ask for a 125% loan-to-value ratio. An 80% or higher loan-to-value ratio makes them cautious about handing you a loan. Cash-out refinance lenders will also do their homework on you, but you can borrow more money with this financing option.
Home Equity Agreement (HEA)
The previous financing options help you get extra cash at a steep cost. As a result, you’ll incur additional debt and may end up with a tight budget. Excessive debt forces people to make difficult decisions about their lifestyles. A home equity agreement provides you with the cash you need without incurring debt. These lenders take a stake in your home instead of requesting monthly payments.
You only pay the company when you sell the property. The company receives a percentage of the proceeds equal to its equity position. If they buy 10% of your home’s equity and you eventually sell for $800,000, the HEA company will make $80,000.
You can buy out a HEA company earlier. Homeowners can buy back their equity position before selling the home. If a company gives you money for a 10% equity position, you will have to buy back at 10% of your home’s newly appraised value.
While this option reduces your debt, the lender capitalizes on your home’s price appreciation. You won’t have a loan, but it can be a more expensive option when it’s time to sell. You can buy out the lender, but their stake will get more difficult to reacquire as your home’s price increases.
Tap into Your Home Equity
Home equity provides homeowners with the capital they need to cover expenses. Investors frequently use this capital to make down payments on new properties to build their real estate portfolios. Regardless of why you need home equity, accessing more of your home’s value is advantageous to allow you to use funds for many purposes.