Determining your home equity
Current appraised value of $400,000 minus a mortgage balance of $140,000 equals $260,000 in home equity.
As home prices rise or fall in your area, your home equity also shifts. Here’s how to figure out how much equity you have in your home — and how to potentially increase it.
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 can help you pursue important personal goals. So understanding how to calculate your equity — 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 help pay for your child’s college tuition, for example. In fact, your home’s equity also could affect whether you need to pay private mortgage insurance and could determine which financing options may be available to you.
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. This includes your primary mortgage as well as any home equity loans or unpaid balances on home equity lines of credit. In a typical example, homeowner Caroline owes $140,000 on a mortgage for her home, which was recently appraised at $400,000.
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 (LTV) ratio. 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 have a mortgage, your LTV ratio is based on your loan balance. Your LTV ratio can affect whether you pay private mortgage insurance or if you might qualify to refinance. With a higher LTV ratio, banks may consider your loan higher risk, which can increase your borrowing costs. A professional appraisal is key to accurately figuring out your LTV ratio. That’s why your lender often will 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%.
If you pay private mortgage insurance (PMI) on your mortgage, keep an eye on your LTV ratio. Your lender is required by federal law to cancel PMI when a home’s LTV ratio is 78% or lower than the home’s original appraised value (provided certain requirements are met). This cancellation is generally preplanned for when your loan balance reaches that percentage. However, if your LTV ratio drops below 80% because of extra payments you made, you have the right to request your lender cancel your PMI. You can also ask your lender to cancel your PMI if the value of your home has increased, which will lower your LTV ratio. But in that case, you may need a new appraisal, and other rules apply, including the length of time you’ve owned your home.
If you’re considering a home equity loan or line of credit, another important calculation is your combined loan-to-value (CLTV) ratio. Your CLTV ratio compares the value of your home with 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 ratio would be if she were approved for it and, since most lenders require your CLTV ratio to be below 85% to qualify for a home equity line of credit, Caroline likely would be eligible.
If your home’s value remains stable, you can build equity (lower your LTV 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 ratio 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 the value of your home increases due to a renovation project, your LTV ratio could drop, depending on how much equity you tapped to cover the costs. But falling home prices in your area could cancel out the value of any improvements you might make.
Building up equity in your home can help you pursue other important goals and provide a financial buffer in case of emergencies. The first step to taking advantage of it is knowing how much you have.
This article was adapted from Better Money Habits®. Visit BetterMoneyHabits.com for more practical financial information.
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