Home equity is a big deal. In fact, the Federal Reserve reports that total home equity grew by $1.165 trillion between 2014 and 2015; today, home equity accounts for 56.9% of household real estate, according to the National Association of Home Builders. But what does home equity really mean? And what happens when you have too little of it — or plenty? Here are the answers.
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What is home equity?
Home equity is the value of the homeowner’s unencumbered interest in their property. In other words, it is the the difference between the appraised value of your home and the amount of mortgage you still owe on the home. Home equity might also be known as ‘real property value.’
Equity begins with the down payment you put on your home, and grows slowly with each payment you make against your mortgage principal. As the value of your home increases, so does your equity — so if you purchase a home at a great rate and over time the property appreciates (as most properties do), you wind up with greater equity.
So what does that mean when it comes to financing? Simply put, the more equity you have in your home, the more financing options are open to you. You can rely on your home equity to secure a home equity line of credit, help you refinance the mortgage for a more favorable interest rate, or look forward to a potentially large return if you choose to sell your home.
How do you calculate home equity?
Your lender uses home equity to calculate the loan-to-value ratio, or (LTV), which is then combined with other factors to determine the amount of loan you might be eligible to receive. In order to do this, the lender takes the current loan balance and divides it by the current appraised value of the property.
Here’s an example: You currently owe $210,000 on your mortgage. Your home appraises for $400,000. Using the LTV calculation, you would divide $210,000 by $400,000, giving you 0.525. This gives you a loan-to-value ratio of 52.5%.
Now, consider the amount of money you want to borrow. For our example, assume it’s $50,000. You would add what you currently owe on the mortgage ($210,000) and the desired loan ($50,000) for a total of $260,000. Now simply divide the $260,000 by $400,000. The result: 0.65, which translates to 65%. This is your combined loan-to-value ratio (CLTV).
But what does that really mean?
Most lenders want to see a CLTV of 85% or less in order to consider awarding a home equity line of credit. In our hypothetical scenario, you would definitely qualify.
Can you get a home equity loan?
Your ability to get a home equity loan is dependent upon more than just how much money you have in the house. Lenders also look at your credit score and debt-to-income ratio, just as they would if you were applying for a mortgage for the first time.
Shoot for a credit score of at least 660 before applying for a home equity loan — that’s what the folks at TD Bank want to see, according to BankRate. Improve your credit by making all payments on time and paying down your balances. Check your credit report at least once per year, and correct any mistakes you might find there.
Read more: Clark Howard’s free credit report guide
To improve your debt-to-income ratio, get rid of as much debt as possible. Pay off credit cards, and work diligently to pay off any car loans. Cut expenses where you can. You want to show that your income is more than enough to pay your debts, including any new ones you might incur through the home equity loan.
Not sure what your debt-to-income ratio is? Here’s an example to help you figure it out: Assume you make $10,000 per month. Your expenses total $4,000 per month. To calculate your ratio, divide your expenses ($4,000) by your income ($10,000). In this hypothetical, your ratio is 0.40, which translates to 40%. A debt-to-income ratio at least in the low 40s is usually required to get a home equity loan.
Finally, you can improve your loan-to-value ratio by paying more on the mortgage principal each month. You could also consider making lump-sum principal payments — that’s a great investment for your tax return! And remember that the value of your home matters a great deal, so spring for home improvements with a nice return on investment, and keep your property very well-maintained, clean and neat.