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| © Shutterstock Couple moves into a new home. |
By Kim Porter, Bankrate
Home equity can be a valuable resource for homeowners. It can be used to fund major home upgrades, pay off high-interest debt, make a big-ticket purchase or meet important financial goals.
Before you explore options to access equity, you should calculate the amount you have in your home. This figure, along with your loan-to-value ratio, determines the likelihood of being approved for a home equity loan or home equity line of credit (HELOC) and how much funding you could be eligible for.
How much equity do you have in your home?
Equity is the difference between your home's appraised value and the amount you owe on your mortgage (and any other loans against the home). It's a relatively simple calculation, assuming you have accurate figures on hand.
Determine how much equity you have
First, identify the property's market value by using an online home price estimator, such as Zillow's Zestimate or Redfin's Estimate. Both are popular online tools that rely on a unique algorithm and publicly available information to generate estimates.
You'll also need the outstanding balance on your mortgage, which can be found on your most recent mortgage statement. You can also check the online dashboard or call your lender directly to get the outstanding balance.
Here's an example of how to calculate your equity:
Assume your home's current market value is $300,000, and you have a $180,000 balance remaining on your mortgage. Subtract the $180,000 outstanding balance from the $300,000 market value. Your calculation would look like this:
- $300,000 - $180,000 = $120,000
In this case, your home equity in this example would be $120,000.
Calculate your loan-to-value ratio
Once you know how much equity you have in your home, you can determine if it's sensible to borrow from it. An important factor is your loan-to-value (LTV) ratio as it helps lenders measure risk before deciding whether to approve or reject a loan application. It is your mortgage balance divided by your home's current market value.
Using the above example, you would make the following calculation:
- $180,000 / $300,000 = 0.60 or 60 percent LTV
A higher LTV ratio indicates more risk for the lender. So, the lender will usually set a maximum LTV ratio of around 85 percent or less. In this case, the LTV falls well within that range, and you could have a chance at being approved for a home equity loan or HELOC, assuming you meet the lender’s other eligibility criteria.
Determine how much you can borrow
Most lenders allow you to borrow up to 75 or 90 percent of your available equity, but each has a unique formula to determine your borrowing threshold.
If the lender allows you to borrow 80 percent, you'd use this calculation:
- ($300,000 [home's value] x 0.80 [maximum percent borrowed]) - $180,000 [amount owed] = $60,000 available to borrow
How to tap into your home equity
Once you know how to calculate home equity and how much you can borrow, you'll need to choose between loan types. The options include:
- Home equity line of credit: A HELOC is flexible and lets you fund multiple projects over time. Once approved, you can borrow up to a set limit during the draw period, which generally lasts for up to 10 years. As with a credit card, you can borrow what you need, pay down the line of credit and borrow again. Interest rates are usually variable and could change over time. Once the draw period ends, the principal balance converts to a loan that's repayable over a set period of up to 20 years.
- Home equity loan: A home equity loan allows you to borrow a lump sum of money upfront and repay it in equal installments with a fixed interest rate. It could be ideal if you know how much you need and prefer a predictable monthly payment and stable interest rate.
Advantages and disadvantages of borrowing equity
Whether you decide on a home equity loan or a HELOC, the funds can be used however you see fit. Many homeowners use the money for home improvement projects, which can increase their home value and help them get the best deals when they eventually sell their homes. Plus, the interest on a home equity loan or HELOC may be tax-deductible if the funds are used for home improvements.
Some borrowers also consolidate high-interest debt or pay for higher-education costs and emergency expenses.
The main drawback of a home equity loan or line of credit, however, is that your home is used as collateral to secure the loan. So if you fall behind on payments, the lender has a legal right to place a lien on your property and foreclose on the home.
Also, be mindful you could end up owing more on your mortgage than what your home is worth if your property value declines after you borrow against the equity. In this scenario, it's much harder to get approved for a new loan with more favorable terms.
Consequently, it's important to borrow only what you need and to make all your payments on time.
Next steps
Calculating home equity is a simple process that only takes a few minutes with the right information on hand.
Read more: What is home equity?
If you find that the equity is not as much as you'd hoped, consider taking steps to build it up, like making extra payments each month or whenever you're able to do so to pay down the principal faster. Also keep in mind that local markets change over time, which can work in your favor. When home prices in your neighborhood tick up, the value of your home increases, which in turn increases your equity.
See more at Bankrate
