WE’VE ALL DONE IT—that mental calculation where you try to figure out
how much you’d clear if you were to sell your house and pay off your
mortgage. But it can be more than just an idle exercise. Even if you
never sell your home, the equity you have in it can help you pursue
important personal goals. So understanding how to calculate it—and how
banks view it—is critical, especially if you want to borrow money
against that equity to pay for a home improvement project, cover
emergency expenses or help pay for your child’s college tuition, for
example. In fact, your home’s equity could also affect whether you
need to pay private mortgage insurance and could determine which
financing options may be available to you.
Start With a Baseline Calculation
You can figure out how much equity you have in your home by subtracting the amount you owe on all loans secured by your house from its appraised value. This includes your primary mortgage as well as any home equity loans or unpaid balances on home equity lines of credit. In a typical example, homeowner Caroline owes $140,000 on a mortgage for her home, which was recently appraised at $400,000.
Next, Take a Look at How Banks Calculate Equity
Mortgage, refinance and home equity loan providers may use additional calculations when deciding how much they’re willing to lend you—or even whether they’re willing to lend to you at all. One measure they use is the loan-to-value (LTV) ratio. When you first apply for a mortgage, this number reflects the amount of the loan you’re seeking relative to the home’s value. If you have a mortgage, your LTV ratio is based on your loan balance. Your LTV ratio can affect whether you pay private mortgage insurance or if you might qualify to refinance. A professional appraisal is key to accurately figuring out your LTV ratio. That’s why your lender will often require an on-site appraisal as part of the process for obtaining a loan. To figure out your LTV ratio, divide your current loan balance—you can find this number on your monthly statement or online account—by your home’s appraised value. Multiply by 100 to convert this number to a percentage. Caroline’s loan-to-value ratio is 35%.
Possible Effects on Insurance
If you pay private mortgage insurance (PMI) on your mortgage, keep an eye on your LTV ratio. Your lender is required by federal law to cancel PMI when a home’s LTV ratio is 78% or lower (provided certain requirements are met). This cancellation is often preplanned for when your loan balance reaches 78% of your home’s original appraised value. However, if your LTV ratio drops below 80% because of extra payments you made, you have the right to request your lender cancel your PMI.
What About Home Equity Loans?
If you’re considering a home equity loan or line of credit, another important calculation is your combined loan-to-value (CLTV) ratio. Your CLTV ratio compares the value of your home with the combined total of the loans secured by it, including the loan or line of credit you’re seeking. Say Caroline wants to apply for a $75,000 home equity line of credit. She calculates what her CLTV ratio would be if she were approved for it, and since most lenders require your CLTV ratio to be below 85% to qualify for a home equity line of credit, Caroline would likely be eligible.
Ways to Potentially Increase Your Equity
If your home’s value remains stable, you can build equity (lower your LTV ratio) by paying down your loan’s principal. If your payments are amortized (that is, based on a schedule by which you’d repay your loan in full by the end of its term), this happens automatically, simply by making your monthly payments. To lower your LTV ratio more quickly, consider paying more than your required payment each month. This helps you chip away at your loan balance. (Check first to make sure your loan doesn’t carry any prepayment penalties.)
Also, protect the value of your home by keeping it neat and
well-maintained. Smart home improvements can help, too. However, it’s
a good idea to consult an appraiser or real estate professional before
investing in any renovations you hope will increase your home’s value.
Remember that economic conditions—and the normal dips and swings of
the real estate market—can affect your home’s value no matter what you
do. If home prices increase, your LTV ratio could drop, but falling
home prices could cancel out the value of any improvements you might
3 Questions to Ask Your Advisor
- Could a home equity line of credit be appropriate for my needs?
- How does my home equity fit into my overall financial picture?
- Besides borrowing for remodeling, what are some ways I might leverage my home equity to help me reach my larger financial goals?
This article was adapted from Better Money Habits®. Visit BetterMoneyHabits.com for more practical financial information.
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This piece was adapted from a piece that originally ran in Better Money Habits®, in partnership with Khan Academy. Visit bettermoneyhabits.com for more practical how-to financial information.
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