Your home is more than a roof over your head — it can be a source of cash, too. Borrowing from your home equity is a fantastic way to pay for renovations or a down payment for a second property. These loans can even help you consolidate debt or pay for unexpected large expenses. Understanding how much equity you have is a simple equation. Here’s how to calculate that number and transform that equity into helpful cash.
What is home equity?
Home equity is determined by a simple calculation: the current value of your property minus the amount you owe on your mortgage.
“It’s basically the part of your house that you ‘own,’ ” said Tendayi Kapfidze, the chief economist at LendingTree, which owns MagnifyMoney.
As you pay off your mortgage and any other liens against the property, your equity will grow. And if you take out any new loans using your home as collateral, that equity will go down. If the value of your home goes up because the market has improved, your equity will increase as well.
For example, let’s say your home is assessed at $250,000, and you currently owe $100,000. Your home equity would be $150,000. (Although you can’t usually take out that full amount as a loan — more on that later.)
How to estimate how much your home is worth
Don’t just guesstimate your home’s worth — and “guesstimating” applies to online market-price estimates you can find by Googling your property address. These numbers may help you make an initial, very rough guess at your home equity — but making plans with that price in mind may leave you disappointed.
“You can’t know exactly how much your home is worth until you get an appraisal,” Kapfidze said.
Appraisers are experts in evaluating home worth. Not only are they familiar with the local market and comparable properties, but they know exactly how your home’s unique features affect the price. An appraiser will produce a report in which they explain exactly how they calculated your home’s worth and provide corroborating evidence.
You can find an appraiser through the International Society of Appraisers or the National Association of Realtors. But keep in mind: Many lenders request an appraisal during the closing process, and you will likely be responsible for that fee, which typically costs between $300 and $400. Depending on your circumstances, you may want to start the loan process with a lender before hiring your own appraiser.
How to tap into your home equity
Once you know how much home equity you have, you can start taking advantage of that extra cash. Home equity can be used to renovate your house, afford a down payment for a second home, consolidate debt, pay for school and more.
But “make sure you use the loan product that fits your situation,” Kapfidze said. Some loan types may cost more in interest over time, but provide much-needed flexibility. Evaluate your needs to decide if you need a home equity loan, a home equity line of credit (HELOC) or a cash-out refinance.
Home equity loans
A home equity loan is the simplest way to use your equity. This loan works much like a mortgage: You take out a fixed amount of money, often at a fixed interest rate and repay the loan in regular monthly installments. Fail to repay the loan? Your home is collateral — and the lender can foreclose on the property.
Most lenders will want you to keep at least 15% equity in your home. So, if you have $150,000 in equity for that $250,000 home, your lender will want you to keep $37,500 in equity. The maximum you’ll be able to borrow is $112,500, and that amount may be even less, depending on your finances and credit.
On the surface, the interest rate for home equity loans may seem higher than the rate for comparable HELOCs. But the security of a fixed interest rate — as opposed to a variable rate — is valuable. Getting the money in a lump sum can be helpful if you’re funding a one-time renovation, like a kitchen upgrade.
Home equity lines of credit (HELOCs)
Lenders’ HELOC loan requirements look very similar to those for home equity loans: Borrowers will often need to keep at least 15% equity, and the exact amount issued will depend on finances and credit. But beyond those basic similarities, HELOCs differ quite a lot.
A HELOC works kind of like a credit card: You withdraw from a revolving line of credit, which can be helpful if you’re funding something like a large, sprawling renovation. You’ll make payments against the amount you’ve borrowed, not the entire loan amount. Most HELOCs set out a fixed “draw time” when you can make withdrawals. After that time ends, you can, depending on your lender, either renew your credit line or enter a repayment period.
How that repayment is structured depends on your lender, too. Some require a single balloon payment — which you should plan ahead for, otherwise you risk a big, expensive surprise that could lead to losing your home. Other repayment periods function much like your mortgage, with monthly payments.
But here’s the big HELOC difference: the interest rate. Whereas most home equity loans offer a fixed interest rate, HELOC interest rates are typically variable. Your initial rate may look low, but it could skyrocket as the loan approaches repayment. Pay attention to a few specific terms to ensure that the loan remains affordable:
- Periodic cap: How much can the interest rate change in one go? This prevents lenders from dramatically increasing the rate, making an inexpensive rate suddenly unaffordable.
- Lifetime cap: How much can the interest rate change over the life of the loan? This is your loan’s worst-case scenario — so make sure you can afford repayment, even if the interest rate increases as much as possible.
A cash-out refinance is quite different from a home equity loan or a HELOC because you’re “getting a new mortgage on your property,” said Kapfidze. “You’re paying off the old mortgage with the new mortgage.”
Let’s say you still own that $250,000 property and have $150,000 in equity. Many lenders will require you to keep 20% equity in your home — so the most you can refinance is for $200,000. Your new $200,000 mortgage will pay off the old $100,000 mortgage and give you the rest in cash.
Why choose cash-out refinancing over a home equity loan or HELOC? Your new mortgage will be one single payment versus two loans. Depending on your finances, this easier payment may be a blessing. And if you’ve owned your home for a while, interest rates may have dropped dramatically. A cash-out refinance may dramatically lower your mortgage payments.
Home equity and LTV: What to know
To calculate your home’s loan-to-value (LTV) ratio, which is written as a percentage, you’ll need to know your home’s appraised value and current mortgage balance. Divide your loan value — say, $100,000 — by the appraised value of $250,000 and then multiply the result by 100 to determine a LTV of 40%.
If you have multiple loans against your property, lenders will look at your combined LTV, or CLTV. This formula adds all loans together and divides that sum by the appraised value. So if you had an existing $40,000 loan on that $250,000 property, your CLTV would be 56%.
Most lenders don’t let homeowners borrow more than 85% of their home’s value, and cash-out finances are often restricted to 80%.
Borrowing from your home equity can be a great way to access cash at a cheaper rate than private loans or credit cards. And if you use the funds to improve your home or buy a new property, you may be able to deduct interest on your taxes. But beware — home equity loans, HELOCs and cash-out refinancing all require you to put your home up as collateral. If you’re willing to bear that risk, these loans can be useful financial options for homeowners.
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