WE’VE ALL DONE IT—that mental calculation where you try to figure out how much you’d clear if you were to sell your house and pay off your mortgage. But it can be more than just an idle exercise. Even if you never sell your home, the equity you have in it can help you pursue important personal goals. So understanding how to calculate it—and how banks view it—is critical, especially if you want to borrow money against that equity to pay for a home improvement project, cover emergency expenses or pay for your child’s college tuition, for instance. In fact, it could also affect whether you need to pay private mortgage insurance, and could determine which financing options may be available to you.
Start with a Baseline Calculation
You can figure out how much equity you have in your home by subtracting the amount you owe on all loans secured by your house from its appraised value. In a typical example, homeowner Caroline owes $140,000 on a mortgage for her home, which was recently appraised at $400,000.
Next, Take a Look at How Banks Calculate Equity
Mortgage, refinance and home equity loan providers may use additional calculations when deciding how much they’re willing to lend you—or even whether they’re willing to lend to you at all. One measure they use is the loan-to-value ratio (LTV). When you first apply for a mortgage, this number reflects the amount of the loan you’re seeking relative to the home’s value. If you currently have a mortgage, your LTV is based on your loan balance. Your LTV ratio can affect whether you pay private mortgage insurance or if you might qualify to refinance. A professional appraisal is key to accurately figuring out your LTV ratio. That’s why your lender will often require an on-site appraisal as part of the process for obtaining a loan.
To figure out your LTV ratio, divide your current loan balance—you can find this number on your monthly statement or online account—by your home’s appraised value. Multiply by 100 to convert this number to a percentage. Caroline’s loan-to-value ratio is 35 percent.
Possible Effects on Insurance
If you currently pay private mortgage insurance (PMI) on your mortgage, keep an eye on your loan-to-value ratio. Your lender is required by federal law to cancel PMI when a home’s LTV is 78 percent or lower (provided certain requirements are met). This cancellation is often preplanned for when your loan balance reaches 78 percent of your home’s original appraised value. However, if your LTV drops below 80 percent ahead of schedule due to extra payments you made, you have the right to request your lender cancel your PMI.
What About Home Equity Loans?
If you’re considering a home equity loan or line of credit, another important calculation is your combined loan-to-value ratio (CLTV). Your CLTV compares the value of your home to the combined total of the loans secured by it, including the loan or line of credit you’re seeking. Say Caroline wants to apply for a $75,000 home equity line of credit. She calculates what her CLTV would be if she were approved for it, and since most lenders require your CLTV to be below 85 percent to qualify for a home equity line of credit, Caroline would likely be eligible.
How to Increase Your Equity
If your home’s value remains stable, you can build equity (lower your loan-to-value ratio) by paying down your loan’s principal. If your payments are amortized (that is, based on a schedule by which you’d repay your loan in full by the end of its term), this happens automatically, simply by making your monthly payments.
To lower your LTV more quickly, consider paying more than your required payment each month. This helps you chip away at your loan balance. (Check first to make sure your loan doesn’t carry any prepayment penalties.)
Also, protect the value of your home by keeping it neat and well-maintained. Smart home improvements can help, too. However, it’s a good idea to consult an appraiser or real estate professional before investing in any renovations you hope will increase your home’s value. Remember that economic conditions—and the normal dips and swings of the real estate market—can affect your home’s value no matter what you do. If home prices increase, your LTV could drop, while falling home prices could cancel out the value of any improvements you might make.
3 Questions to Ask Your Advisor
- Which is best for my needs—a home equity loan or a line of credit?
- How does my home equity fit into my overall financial picture?
- Besides a loan for remodeling, what are some ways I might leverage my home equity to help me reach my larger financial goals?
This article was adapted from Better Money Habits®. Visit BetterMoneyHabits.com for more practical financial information.
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This piece was adapted from a piece that originally ran in Better Money Habits®, in partnership with Khan Academy. Visit bettermoneyhabits.com for more practical how-to financial information.
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