Even people who haven’t fully paid off their mortgages own a certain percentage of the value of their homes. This amount, called home equity, is a combination of the money a borrower put down to buy the home, the money they have paid off (not including interest) on the mortgage, and the amount the house has accrued in value since the original purchase price. Like any high-value asset, there are multiple ways to access home equity, but first, you need to understand how to calculate it.
How to Calculate the Equity in Your Home
There is a simple formula to calculate your home equity. Take the appraised value of your home and subtract the amount you owe. You can find estimates of your home’s value on online real estate sites, but you need to hire an appraiser for a more accurate appraised value. If you are considering taking a new mortgage, hiring an appraiser will be part of the process.
If your home value has increased since you purchased it, your home equity will likely increase. Of course, the opposite is also true. If the market value of your home decreases, you will have less equity. Occasionally, the market value of a home dips below the remaining balance of the mortgage. This is called being underwater on your mortgage.
How to Build Home Equity
If your home appreciates due to market conditions, then your home equity will also increase. You don’t have control over market fluctuations, but here are a few ways to build home equity you can control. Here are the three most common ways to increase home equity:
- Make a large down payment. If you make a $25,000 versus a $10,000 down payment, you will automatically have more equity because you own a larger interest in your home.
- Make extra mortgage payments. You are automatically building more equity while making a monthly mortgage payment. However, if you make additional payments toward the principal, you can build more equity in your home.
- Make home improvements. Depending on the home improvements you make to your home, you could increase your equity. Keep in mind that certain home improvements add more value to your property than others do.
Is it Possible to Lose Home Equity?
Home equity isn’t a constant number. It’s a good idea to be strategic and proactive when you have a lot of it. Like any investment, you should consider your interest in your home as something you can leverage. Here are three typical ways to lose home equity:
- Home value decreases. The housing market’s ups and downs impact your home’s value. If the supply of homes exceeds demand, the value of your home may also go down.
- Declining home condition. If your home looks run down and isn’t properly maintained, there is a possibility it will be valued lower.
- An overall decline in the neighborhood. Sometimes home equity values may decrease because various amenities aren’t available anymore or a school’s reputation is on the downturn.
Using Home Equity Strategically
Equity is an asset that you can use to your advantage. Many people don’t consider their home an asset, but here are a few ways to leverage it to your advantage.
- Cash-out. Selling your home when the market value is at its highest may allow you to pay off your mortgage and make a profit. You could also cash out by refinancing your home.
- Borrow from it. With a home equity loan or a home equity line of credit, you can access equity for various purposes. The interest rate on home equity loans is usually lower than borrowing on a credit card.
- Reverse Mortgage. If you are 62 years or older, a reverse mortgage can allow you to tap your equity in various ways and forgo making monthly mortgage payments.
How Lenders Determine How Much You Can Borrow
Having a large amount of home equity works to your advantage when applying for a loan. Lenders generally look to home equity to calculate the risk involved in giving a borrower credit. One way this risk is measured is through the loan-to-value (LTV) ratio, which is considered when you’re buying or selling a home, refinancing a mortgage, or applying for a home equity loan. It is a formula used to measure the ratio between your requested loan amount and the home’s current market value. With a low LTV, you appear less risky to lenders.
To calculate your loan-to-value ratio, take your current loan balance and divide it by the current appraised value of your home multiplied by 100. If you get a $70,000 mortgage to buy a $100,000 home, then your loan-to-value ratio is 70% because you got a loan for 70% of the home’s value.
Home equity is a simple concept, but understanding how it works and how to use it can be a powerful tool that helps homeowners make the most of their borrowing power.
This article is intended for general informational and educational purposes only, and should not be construed as financial or tax advice. For more information about whether a reverse mortgage may be right for you, you should consult an independent financial advisor. For tax advice, please consult a tax professional.