If you’re a homeowner, it is important to understand your home equity and how to calculate it. Home equity is the difference between the appraised value of your home and the amount you still owe on your mortgage. Increasing your equity can help improve your finances; it affects everything from whether you need to pay private mortgage insurance to what financing options may be available to you.
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. For example, homeowner Caroline owes $140,000 on a mortgage for her home, which was recently appraised at $400,000. Her home equity is $260,000.
However, if Caroline’s home was appraised at a value lower than what she owes on her mortgage, she would not have any equity in her home and would owe more than the home is worth.
Lenders may use other calculations related to equity when making decisions about loans. One common measure used is loan-to-value ratio (LTV). When you first apply for a mortgage, this equation compares the amount of the loan you’re seeking to the home’s value. If you currently have a mortgage, your LTV ratio is based on your loan balance. LTV ratio can affect whether you pay private mortgage insurance or if you might qualify to refinance.
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 that number by 100 to convert it to a percentage. Caroline’s loan-to-value ratio is 35 percent.
Tip: Getting a professional home appraisal is an essential part of determining your loan-to-value ratio. If an on-site appraisal is needed, your lender will arrange for a qualified appraiser to come to your home and assess its value. While a home appraisal is the most accurate way of determining what your home is worth, there may be free online tools that can also help you understand your home’s estimated value.
If you pay private mortgage insurance (PMI) on your original mortgage, keep track of your loan-to-value ratio. The Homeowners Protection Act requires lenders to automatically cancel PMI when a home’s LTV ratio is 78 percent or lower (provided certain requirements are met). This cancellation is often preplanned for when your loan balance reaches 78 percent of your home’s original appraised value. However, if your LTV ratio drops below 80 percent ahead of schedule due to extra payments you made, you have the right to request your lender cancel your PMI.
If you are considering a home equity loan or line of credit, another important calculation is your combined loan-to-value ratio (CLTV). Your CLTV ratio compares the value of your home to 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 and currently has a loan balance of $140,000. She calculates what her CLTV ratio would be if she were approved for it:
Most lenders require your CLTV ratio to be below 85 percent (though that number may be lower or vary from lender to lender) to qualify for a home equity line of credit, so Caroline would likely be eligible. However, it’s important to remember that your home’s value can fluctuate over time. If the value drops, you may not be eligible for a home equity loan or line of credit, or you may end up owing more than your home is worth.
If your home’s value decreases over time, your equity may decrease, too. But, if it remains stable, you can build equity by paying down your loan’s principal and lowering your loan-to-value ratio. 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 simply by making your monthly payments.
If you hope to lower your LTV ratio more quickly, consider paying more than your required mortgage payment each month. This helps you chip away at your loan balance. (Check 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. You may also be able to increase your home’s value by making improvements to it. 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 can affect your home’s value no matter what you do. If home prices increase, your LTV ratio could drop and your home equity could increase, while falling home prices could cancel out the value of any improvements you might make.