What is Home Equity?

Most American homeowners purchase their homes via mortgages. Other alternatives to finance buying homes may be rent-to-own strategies and even one-time cash payments.

When comparing a home's mortgage to its current worth, the difference is what makes the difference. This difference is called home equity. For instance, if your home's mortgage costs about $500,000 and the actual value of your home is $750,000, then your home equity is $250,000. It is important to note that your home equity could either dip or increase.

Calculating Home Equity

The crux of the matter: how do you calculate how much your home equity is? In some cases, like the one above, it might be relatively easy to calculate your home equity as it constitutes the difference between the home's mortgage and what it is currently worth in the market. However, from a more detailed view, here is what to consider when calculating your home equity:

Know your home's market value

There are online price estimators, such as Zillow. Such price estimators may give you a rough feel of your home's market value, so do not overly rely on them. A way to confirm this premise is by considering different online price estimators. You may get a different market value from each price estimator for the same home.

The best way to do this is by consulting a real estate professional. Agents constantly on the ground can tell you why your home is valued at a lower price than what you expected or why an improvement may instantly increase its value.

Home appraisals also do the trick and bring years of experience and expertise into this valuation process. Real estate appraisers are licensed and certified to do proper and effective valuations on real estate properties. They technically compare other homes around yours and offer their valued opinion on your home's best price. You can request a Comparative Market Analysis (CMA) report from your agent.

Know your mortgage's balance

The next step is to confirm how much you must pay to finalize your mortgage payment, namely, how much more is required to attain freedom. There are diverse ways to obtain this figure:

• Good recordkeeping can save you time and energy. If you are an individual who likes to jot down every transaction they do with their finances, then calculating how much mortgage balance you owe might be a simple job.
• From your mortgage provider. Since they, too, need to keep accurate and updated records of your payments, they can help you know the difference.
• Recent financial statements. Loan statements clearly tell you what you should pay to complete your mortgage payments.

Get the difference between your home's market value and your mortgage balance.

After having both figures in mind, your home equity is the difference between your mortgage balance from your home's market value.

Home Equity = Home's Market Value – Home's Mortgage Balance

In such formulas with three expressions, each can be found as a relation between the other two. We already have the formula for finding home equity. Now to find:

Home's market value = Home equity + Home's mortgage balance

Home's mortgage balance = Home's market value – Home equity

An example: Consider a home whose mortgage balance is $100,000 and whose market value is estimated to be $400,000. To calculate the home equity:

$400,000 - $100,000 = $300,000

Loan-to-value (LTV) ratio

Your home equity can then be used to check whether you qualify for a home equity loan. To do this, you also need to calculate your loan-to-value ratio. Most lenders use this figure to determine if they should lend to you or not. An LTV of 80% is best preferred.

Loan-to-value (LTV) Ratio = Home’s Mortgage Balance / Home’s Market Value (×100 for percentage)

An example of this in use: Suppose your home equity is $300,000, a mortgage balance of $100,000, and the lender you are considering only allows an LTV of 80%. Using your mortgage balance and your home's equity, your home's market value is the sum, which is $400,000.

Now, with these statistics in mind:

Home equity = $300,000

Home’s market value = $400,000

Home’s mortgage balance = $100,000

Lender’s LTV = 80%

You can now calculate how much the lender is willing to give you as a home equity loan or a home equity line of credit, which should be 80% of your home's market value.

80% × $400,000 = $320,000

This means you can only borrow $20,000 of your home equity to get a home loan. Most real estate professionals advise against borrowing an LTV above $150,000 of your home equity. This will increase your debt payment obligations when you sell the home.

An important factor to consider: how do home equity loans and home equity lines of credit (HELOCs) work alongside initial mortgages on the home? Indeed, these two are debt obligations in preceding orders: Home equity loans and HELOCs come after your first mortgage. The LTV ratios for both home financing methods also differ. For standard mortgages, the maximum LTV ratio is 80%, while for home equity loans and HELOCs, the ratio rises to 85%.

Building your home equity

Using the home equity formula above, we can deduce that to increase the value we get on the home equity's expression; we can either increase the home's market value or reduce the home's mortgage balance. The several ways to do this include:

• Contributing large amounts of money for your home's initial down payment.
• You can also choose to live in your home for the maximum time possible.
• Make monthly mortgage payments promptly.
• Select short-term mortgage payments.
• Pay extra whenever you can.
• Increase your home's value through renovations and improvements.

Using your home equity

Now that you have calculated your home equity, you can use this figure to your advantage. Some of these ways include:

• You can use your home equity to purchase a new home.
• You can borrow against your home equity and access home equity loans.
• You can improve certain aspects of your home and make renovations.
• You can pay off pending bills, such as school fees.