Home equity is the difference between what you still owe on your mortgage and the current appraised value of your home. Expressed as a percentage, it’s the portion of your home that you’ve paid for and fully own.
Every time you make a monthly payment and chip away at your mortgage loan balance, you’ll be building equity. If your home value goes up, that will also increase your equity.
Equity is valuable because it allows you to borrow money against your home at lower interest rates than other types of financing, such as personal loans and credit cards. You might consider tapping into your home equity for a variety of reasons. Here’s what you need to know about home equity, including how to calculate it and different ways to leverage it.
How home equity works
Once you have enough equity built up in your home, lenders and banks will allow you to borrow against it through a cash-out refinance, a home equity loan or a home equity line of credit. Many people use their home equity to make home improvements, pay for education costs or consolidate high-interest debt.
Most lenders want to see that you’ve built up at least 15% to 20% equity before approving you for any type of home equity financing. You may need to work with an appraiser or real estate agent to get an accurate evaluation of your home’s appraised value.
One of the simplest ways to ensure you have a good chunk of equity in your home is to make a larger down payment when you buy. For a typical homeowner with a 30-year fixed-rate mortgage, building up 15% to 20% equity usually takes about five to 10 years.
How do you calculate home equity?
There are a few important steps when calculating how much equity you have in your home. Even if you paid less for your home when you bought it years ago, home equity is based on the current market value of your house. Most lenders will require an up-to-date home appraisal conducted by a professional to accurately determine your home value.
Once you have an appraisal, look up your outstanding mortgage balance and subtract it from the current market 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 worth of equity in your home.
When applying for a home equity loan or a home equity line of credit, the next step is to determine your loan-to-value ratio. Your LTV ratio is your outstanding mortgage balance divided by your home’s current value. 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.
How to calculate your home equity loan amount
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 market value] X 0.85 [maximum equity percentage you can borrow] – $400,000 [outstanding mortgage balance] = $25,000 [what the lender will let you borrow]
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.
How to increase your home’s equity
Putting a large down payment on a home of 20% ensures you have a significant amount of equity in your house before you move in. But if you are unable to pay that amount of cash upfront, there are a few other options to consider.
When you close on a home, try to avoid rolling over closing costs onto your mortgage. This increases the size of your home loan and simultaneously decreases your equity.
Another option is to pay more toward your monthly mortgage payment so you can start reducing your principal balance instead of just paying off interest. You can also refinance your mortgage to a shorter term -- for example, from a 30-year mortgage to a 15-year mortgage. Though your monthly payments will be higher, you’ll be able to build equity faster with a shorter loan term -- if you are able to afford the higher payments.
Additionally, remember that property values generally tend to go up over the term of a loan. So as you make your monthly mortgage payments and your home goes up in value, the difference between what your property is worth and what you owe your mortgage lender will be greater, thereby increasing your equity.
Ways to borrow against home equity
There are various ways to access the equity in your home. Some of the most common options are home equity loans, home equity lines of credit (HELOCs) and reverse mortgages.
Unlike unsecured loans, such as personal loans, all of these options require you to put up your home as collateral to secure the loan, meaning there is a risk of losing your home to foreclosure if you miss payments or default on the loan for any reason.
Home equity loan
A home equity loan is a second mortgage that lets you borrow money against the equity in your home and provides you with one lump sum of cash at a fixed interest rate that never changes. Lenders typically want to see that you have at least 15% to 20% in home equity to approve you. 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. Because borrowing is currently expensive overall, home equity loan rates are higher than they’ve been in the past.
HELOC
A home equity line of credit, or HELOC, is a more flexible type of loan that lets you borrow against the equity in your home and functions like a credit card. It is a second mortgage that provides an open line of credit that you can access for a certain amount of time, typically 10 years, followed by a set repayment period, usually 20 years. Lenders generally want you to have at least 15% to 20% in home equity 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.
Unlike home equity loans, HELOCs have variable interest rates. That’s why it’s important to make sure you can afford higher monthly payments if your rate goes up after your introductory interest rate expires.
Reverse mortgage
You must be 62 years or older to access a reverse mortgage and either have paid off your home or built up significant equity, usually at least 50%. With a reverse mortgage, you don’t have to make monthly mortgage payments -- the bank or lender actually makes payments to you. However, you must still pay property taxes and homeowners insurance and continue to live in the house. A reverse mortgage allows you to access your home equity and use funds for an extended period of time during retirement.
Keep in mind that as you borrow against your equity, you are building a mortgage balance back up, 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.
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 rate, but it replaces your current mortgage with an entirely new mortgage that has more attractive terms. The lump sum you borrow against your home equity is added back to the balance of your mortgage and you pay it off as one monthly payment.
Is using home equity a good idea?
Home equity loans or HELOCs are often used to pay for home improvement projects that wind up increasing your home’s property value, but the money can be used for anything you want. However, since your home is collateral for the loan, it’s not recommended to take out a home equity loan or HELOC without understanding the risks or without a repayment plan in place.
Can the equity in your home change?
More often than not, your home equity will increase over time, as you pay down the principal amount owed to your bank and your property value increases.
But in some instances, your home equity can actually decrease. If you paid for a home that has gone down in value, your equity will decrease along with it.
The bottom line
Put simply, home equity is the current price of your home minus all outstanding debts on it, but there’s more to it than that. When applying for home equity financing, the appraised value and the loan-to-value ratio of your house will affect the size of loan you’re eligible for. When comparing different types of home loans, it’s important to also consider the interest rate, as well as any costs and fees associated with the loan, to ensure you can comfortably afford to pay it off.
