Home equity is a powerful financial tool for homeowners. It can be used to renovate your home, pay off debt, cover education costs, start a business, or fund almost any other expense.

Before you can leverage this asset, you need to know how much equity you have. This amount, along with your loan-to-value (LTV) ratio, plays a key role in determining your eligibility for a home equity loan or line of credit (HELOC), and how much you might be able to borrow. Here is a step-by-step guide to calculating your home equity.

 

Understanding Key Terms

Home Equity

Home equity is the difference between your home’s current market value and the outstanding balance on your mortgage (and any other loans against the home).

Loan-to-Value Ratio (LTV)

LTV is the percentage of your home’s value that is financed by your mortgage. It’s calculated by dividing your mortgage balance by your home’s appraised value and multiplying by 100. Lenders consider this ratio when deciding whether to approve your mortgage or other home-based financing.

Combined Loan-to-Value Ratio (CLTV)

When applying for a second mortgage, lenders calculate your CLTV, which considers the total debt secured by the home, including both your original mortgage and the amount you wish to borrow through a home equity loan or line of credit.

 

How to Calculate Your Home Equity

Calculating your home equity involves simple math. Here is how you can do it:

Step 1: Estimate Your Home’s Market Value

The first step is to determine your property’s current market value. There are several ways to do this, including online home price estimators. These tools provide a free, quick estimate based on algorithms and publicly available data. However, keep in mind that these are just estimates and may not reflect the exact amount your home could sell for.

When you use an online estimator, you’ll get an estimated fair market value of your home. This value might differ from the appraised value, which is what lenders rely on when determining your equity and borrowing potential. The fair market value represents what a buyer might be willing to pay for your home in today’s market.

Step 2: Determine What You Owe

Next, find out the current balance on your mortgage. This information is typically available on your most recent mortgage statement or through your lender’s online portal. You can also contact your lender directly to obtain this figure.

Step 3: Calculate Your Home Equity

Once you know your home’s market value and your outstanding mortgage balance, calculating your equity is simple: subtract the mortgage balance from the home’s value. For example, if your home is worth $410,000 and your remaining mortgage balance is $220,000, your equity calculation would be: $410,000 (home value) – $220,000 (mortgage balance) = $190,000 in equity.

In this scenario, you have $190,000 in home equity, representing a 46% stake in your property.

Step 4: Estimate How Much You Can Borrow

Lenders typically allow you to borrow up to 80% of your home’s value.

Continuing with our example, 80% of $410,000 is $328,000. Subtracting your $220,000 mortgage balance from this amount gives you $108,000 in tappable equity.

To estimate your potential borrowing power, the full calculation looks like this: $410,000 (home value) x 0.80 (maximum LTV) – $220,000 (mortgage balance) = $108,000 available to borrow

Remember, borrowing against your home equity isn’t free. Like traditional mortgages, home equity loans come with closing costs, including fees for loan origination, appraisals, credit reports, and title searches.

 

Calculating Your LTV and CLTV Ratios

Understanding your LTV and CLTV ratios is crucial when considering borrowing against your home equity. These ratios give lenders insight into your borrowing risk. To calculate your LTV ratio, divide your mortgage balance by your home’s market value and multiply by 100.

Using our earlier example: $220,000 (mortgage balance) / $410,000 (home value) = 0.5365, or 53.65% LTV

If you are applying for a home equity loan, lenders will also consider your CLTV ratio, which includes the total of all loans secured by your home. If you take out a $30,000 home equity loan, your CLTV ratio would be: ($220,000 + $30,000) / $410,000 = 0.6097, or 60.97% CLTV

Lenders view higher LTV and CLTV ratios as higher risk, which can result in higher interest rates.

 

Accessing Your Home Equity

Once you have calculated your home equity and estimated how much you can borrow, you’ll need to decide which type of loan is best for your needs. The main options include:

Home Equity Loans:  A home equity loan provides a lump sum that you repay in fixed installments at a set interest rate. This option is ideal if you know exactly how much you need and prefer a predictable monthly payment.

Home Equity Lines of Credit (HELOCs):  A HELOC offers more flexibility, allowing you to borrow as needed during a draw period, typically lasting 10 years. You only pay interest on what you borrow, and once the draw period ends, you repay the balance over a set term, often up to 20 years.

Cash-Out Refinancing: With a cash-out refinance, you replace your existing mortgage with a new, larger loan. The difference between the old and new mortgage amounts is given to you as a lump sum. This option may offer lower interest rates compared to other forms of borrowing, but it could result in higher long-term costs if the new mortgage rate is higher than your original rate.

 

Impact of Home Equity Loans on Private Mortgage Insurance (PMI)

If you are paying PMI on your original mortgage, taking out a home equity loan generally will not affect your PMI payments. However, it could delay the removal of PMI if it increases your lender’s risk. PMI is typically required on conventional mortgages when the down payment is less than 20%, resulting in an LTV ratio over 80%. You can usually request PMI cancellation once your LTV reaches 80%, and lenders are required by law to cancel it at 78%. However, if you take on additional debt through a home equity loan or HELOC, your lender might require you to wait until your LTV is lower before canceling PMI.

 

In Conclusion

Tapping into your home equity can be a smart financial move, but it's important to understand the numbers and loan options involved. By accurately calculating your home equity and understanding your loan-to-value ratios, you can make informed decisions about whether a home equity loan, HELOC, or cash-out refinance is right for you. If you're unsure of your home’s current value or how to proceed, contact Scott and the Smolen Team for expert guidance. We’re here to help you explore your options and maximize your home’s financial potential.