What Is Home Equity?

Home equity is the difference between what you owe on your mortgage and the current value of your home.

You build equity in your home by consistently making mortgage payments over the years. Equity is valuable because it allows you to borrow money against your home at lower interest rates than other types of financing. Most homeowners now have more equity in their homes than they did two years ago, thanks to surging home values during the pandemic, which means that right now is a good time to consider tapping into your home equity.

Here’s what you need to know about home equity, what it is, how to calculate it and why it’s important to homeowners.

How home equity works 

Most lenders want to see that you’ve built up at least 15% to 20% in equity in order to let you borrow money against your house in the form of refinancing or other kinds of home equity loans. One of the simplest ways to ensure you have a good chunk of equity in your home is to make a large down payment if you’re able to. For a typical homeowner with a 30-year fixed-rate mortgage, building up 15% to 20% equity usually takes about five to 10 years.

Once you have enough equity built up in your home, lenders and banks will allow you to borrow against it. Some of the most common reasons to borrow against your equity are to pay for life expenses such as home improvements, higher education costs including tuition, or to pay off high-interest credit card debt.

How do you calculate home equity?

There are a few important steps to take when trying to calculate your home equity. Even if you paid less for your home when you bought it years ago, the way home equity works is that your equity is based on the present-day value of your house, and most lenders will require an up-to-date home appraisal conducted by a professional to accurately determine your home’s current appraised value. 

Once you have a current appraisal, look up your outstanding mortgage balance and subtract it from the appraised value. If, for example, your home is currently worth $500,000 and you have $400,000 left to pay on your mortgage, then you have $100,000 of equity in your home. 

$500,000 – $400,000 = $100,000

The next step is to determine your loan-to-value ratio, or LTV ratio, which is your outstanding mortgage balance divided by your home’s current value (your combined loan-to-value ratio, or CLTV ratio, is simply the ratio of all outstanding loans secured against your property divided by your home’s current value. Most lenders want to see a CLTV of 85% or lower). So for a $500,000 home, the calculation would be: 

$400,000 / $500,000 = 0.80

That formula means you have an 80% LTV ratio. Most lenders will let you borrow in the neighborhood of 75% to 90% of your available home equity, but having a high LTV tells a lender you may be a risky borrower. To determine if you’ll hit that threshold you can use the below formula, which assumes a lender will allow you to borrow up to 85% of your home equity:

$500,000 [current appraised value] X 0.85 [maximum equity percentage you can borrow] – $400,000 [outstanding mortgage balance] = $25,000 [what the lender will let you borrow]

An example of home equity

To calculate your home equity, simply subtract your remaining mortgage balance from the current appraised value of your home. If, for example, you owe $400,000 on your mortgage and your house is worth $500,000, you have $100,000, or 20% equity in your home.

You may need to work with an appraiser or real estate agent in order to get an accurate evaluation of your home’s appraised value, especially because home values have risen by record-breaking amounts since the beginning of the pandemic. You can also use a home equity calculator to determine whether you have enough equity available in your home to qualify for a typical home equity loan.

Ways to borrow against home equity 

There are various ways to access the equity in your home. Some of the most common equity financing options are home equity loans, home equity lines of credit (or HELOCs) and reverse mortgages. It’s important, however, to keep in mind that all of these options require you to put up your home as collateral to secure the loan, so it’s critical to understand that there’s a risk of losing your home to foreclosure if you miss payments or default on your loan for any reason. 

Home equity loan

A home equity loan lets you borrow money against the equity you’ve built in your home and provides you with a lump sum of cash at a fixed interest rate. Lenders typically want to see that you have at least 15% to 20% in your home to approve you for a home equity loan. A home equity loan doesn’t replace your mortgage like a refinance, rather, it’s an entirely new loan that you’ll repay monthly along with your existing mortgage payment. But just like a mortgage, with a home equity loan, your interest rate never changes and your monthly payments are fixed, too.

HELOC

A home equity line of credit, or HELOC, is a type of loan that lets you borrow against the equity you’ve built up in your home and functions like a credit card. It provides you with an open line of credit that you can access for a certain amount of time, typically 10 years, followed by a set repayment period, which is usually 20 years. Lenders also generally want you to have at least 15% to 20% in your home for HELOC approval. With a HELOC, you don’t have to take all of your funds out at once, and you can withdraw money repeatedly from your HELOC over the 10-year period, once previously borrowed sums are paid back.

“A HELOC offers more flexibility than a home equity loan -- you can’t withdraw money from a home equity loan like you can with a HELOC, and a HELOC allows you to receive replenished funds as you pay your outstanding balance,” said Robert Heck, VP of Mortgage at Morty, an online mortgage marketplace.

HELOCs have variable interest rates however, so it’s important to make sure you can afford higher monthly payments if your rate goes up once your introductory interest rate expires, especially in the current economic climate. 

Reverse mortgage  

You must be 62 years or older to access a reverse mortgage and have either paid off your home or have significant equity accumulated, usually at least 50%. With a reverse mortgage, you do not have to make monthly mortgage payments and the bank or lender actually makes payments to you. You must still pay your property taxes and homeowners insurance and continue to live in the house, however. A reverse mortgage allows you to access the equity in your home and not pay back the funds for an extended period of time while using them for other expenses during retirement.

It’s important to keep in mind that you are building a mortgage balance back up as you borrow against your equity, and your estate will eventually have to pay off your loan. A common way to repay this loan is to sell your house.

Fixed-rate line of credit

A fixed-rate line of credit is essentially a hybrid of a HELOC and a home equity loan. This type of home loan works like a regular HELOC, but the difference is that unlike a standard HELOC – which has a variable interest rate that rises and falls with economic conditions – you will pay the same fixed-interest rate on the principal balance and every single draw, no matter the amount or when you withdraw your funds, which could be advantageous in today’s rising interest rate environment. 

Some banks and lenders may let you refinance a HELOC into a fixed-rate HELOC or a home equity loan depending on the specific options available to you and your personal financial situation.

Cash-out refinance

Similar to a home equity loan, a cash-out refinance provides you with a lump sum of cash at a fixed-interest, but it replaces your current mortgage with an entirely new mortgage that has more attractive terms, mainly a lower interest rate. The lump sum you borrow against your home equity is added back on the balance of your mortgage and you pay it off as one monthly payment. However, with mortgage rates at 14-year highs, it’s unlikely that a cash-out refi will make sense for most homeowners in today’s rising interest rate environment.