Home equity. It’s what makes home ownership (and all the ups and downs that come with it) worth it. Having equity in your home means all those mortgage payments are finally starting to pay off, and you’re building wealth while enjoying one of the largest investments you’ll probably ever make.
You might not think much about your home equity on a day-to-day basis, and that’s all fine and good. But if you find yourself in a position where you want (or need) to move and purchase another home, you can bet you’ll quickly be asking yourself, how much equity do I have in my home?
What is home equity?
When you sell your home, you’ll have to pay the unpaid portion of your mortgage to the bank. That’s easy to do if your home has appreciated in value over the years since you first took out the loan. If it has, you’ll have excess money—or home equity—at your disposal. Home equity is the amount of money you’ve paid into owning your home.
If you don’t have equity, it becomes much more difficult to come up with the money needed to pay off your current mortgage, let alone a down payment on the next property you’ve got your eye on. Let’s look at two very different examples.
The Jones family decides that they need a much bigger home to live comfortably. Their current home, for which they paid $385,000, is currently valued at only $380,000. Since their loan was an interest-only loan, they have paid $0 toward the principal balance since moving into their home five years ago.
Jones family equity = -$5,000 ($380,000 value - $385,000 loan balance)
Assuming they sell the home at its current valuation, not only will they owe the bank the remaining $5,000, they must come up with the down payment for their new home from savings or elsewhere.
The Smart family is moving to a different town and will need to purchase a new home. Their current home, for which they paid $385,000, is currently valued at $390,000. The family also put $20,000 down on the home and has paid off $85,000 of their principal balance—leaving them with a loan balance of $280,000.
Smart family equity = $110K ($390,000 value - $280,000 loan balance)
Clearly, the Smart family will be in a much better financial situation when it comes time to purchase a new home. As shown in the example of the Jones family, without equity you are stuck with a depreciating asset (essentially a money drain) said Oli Watson, a real estate agent with Dwell.
“Given that negative or little home equity is usually caused by stagnating or declining house prices, this can become a vicious cycle for homeowners where they cannot afford to move and are also losing money on their existing home,” he added.
How to calculate home equity
Hoping to avoid a situation like the Jones’ above? It helps to have an understanding of how to calculate home equity if you’re wondering, “how much equity do I have?” As the above examples highlight, calculating how much equity you have in your home is as simple as subtracting your remaining mortgage balance from the appraised value of your home. So, for instance, if your home is valued at $400,000 and you owe $100,000 on it, you have $300,000 equity in your home. In this case, if you decide to move, you’ll take the first $100K to pay off your loan, then you will have $200K to put toward the purchase price of a new home.
Another term you might hear when discussing equity is your loan-to-value ratio, or LTV. According to Watson, this is the ratio of the amount of money you are borrowing to finance a house compared to the overall value of a home. It’s a way for banks to assign a level of risk to the loan they’ll be lending you. Most banks are comfortable with an LTV anywhere between 50 and 90%, said Watson, and this depends on several external factors.
To calculate LTV, you need a value for the home, said Andrew Chen, founder of personal finance website Hack Your Wealth.
“Mortgage lenders typically use the appraised value of a home to determine its value, then apply a percentage like 80% to that value to determine the allowable LTV for the mortgage loan. That percentage is based on the lender’s lending criteria and standards.
Say you want to buy a home that’s $300,000 but you have no equity to roll into this purchase and you’ve only saved $6,000 to put down. That means your LTV is 98 %—you’ll be financing 98% of your home. Most banks would consider that a pretty risky investment.
If, however, you have $130K in equity from the home you just sold to put down on the same $300,000 home, your LTV would be only 56% (300,000-130,000 divided by 300,000)—a much safer investment in the bank’s eyes.
How can I increase my home’s equity?
There are two basic ways to increase the amount of equity you have in your home: decrease the amount you owe on the home or increase the home’s value. Throwing extra money at your monthly mortgage payment is the best way to decrease the amount you owe. But luckily, you’ve got some options when it comes to increasing the value of your home without necessarily having to pay more towards your principal each month.
Appreciation in value. Your home may naturally appreciate in value, especially if it’s in an area that’s enjoying healthy growth. This increase turns into equity in your home, since it’s an asset you own. Though this appreciation is factored into your personal assets, you won’t use it until you go to sell your home (except in the case of a HELOC, or home equity line of credit).
Home improvement projects. According to Watson, the best way to increase the value of your home through making changes to it are by building an extension, renovating the space you already have, or redecorating the space you already have.
“Of course, all these options cost money and need to be done in the right way, so there is an inherent risk to each. If you aren’t experienced in renovations, the best course of action is to copy what people in similar homes and neighborhoods have done to successfully add value to their home,” he said.
It’s worth noting that not all home improvements are created equal. New custom Shaker style cabinets, for example, may be more appealing to you, and may even be something you’d be willing to pay more for in your next home. But when it comes time for a bank-ordered appraisal, they’ll likely add little to no value to the home—meaning you’re out the cost of the investment with no real return.
The point is, if you intend to use renovations to increase equity, consult with a professional to determine where your money’s best spent.
Using your home equity: What is a HELOC?
In most cases, you’ll use the equity you’ve built in your home when you buy a new one. However, there is a way to tap into it earlier, and that’s through taking out a home equity line of credit. “A HELOC is money taken out against the value of your home (like a second mortgage) but it can be used for other things than just to pay for your home,” Watson said.
Is a HELOC a good idea? It can be in some cases, said Watson.
“Taking out a HELOC is only a good idea if you can be confident that your house price can rise to cover the money you take out and more. They are particularly suitable if you own property in an area that has suddenly gained affluence. This is because your house value will rise, but so will your expenses. A HELOC can help you cover those expenses in the short term, while your property covers you in the long term.”
But if you’re just looking for easy money to use in frivolous ways instead of investing either in your home or in other appreciable assets, avoid taking out a HELOC.
“You are selling part of your home to take out the HELOC, and its interest rate will be higher than your conventional mortgage, so reckless spending can cause you to lose your home if you are unable to repay either the HELOC or your mortgage,” Chen warned.
Building your financial future
As a homeowner, it’s great to know the answer to the question, “how much equity do I have?” Whether you use it to make a wise investment in the short-term or save it to make it possible for you to buy a more expensive home in the future, home equity is a large part of your wealth picture. As with any investment, it pays to let it grow over time. The longer you’re able to stay in your home, the more your home equity should grow.