You’ve probably heard the phrase “home equity” thrown around, likely during a fast-paced radio or TV commercial urging you to pull the equity out of your home.
So what the heck is it, and why do mortgage lenders keep bringing it up? It must be important, right?
Let’s learn more about home equity so you can determine if it’s something you should be tinkering with.
In short, home equity is your ownership in an underlying property, minus any liens (mortgages) a bank or lender may have against it.
To calculate, simply take the current market value of your property and subtract any outstanding liens/mortgage balances.
It’s actually pretty easy to figure out how much equity you’ve got in your home, as long as you know what your home is worth. But that’s often the sticking point.
A home value estimator like Zillow’s Zestimate or the Redfin Estimate, or your own personal opinion, might not align with what the bank or lender feels your home is worth.
Home Equity Example
Current property value: $500,000
Existing liens: $350,000 first mortgage, $100,000 second mortgage
Home equity: $50,000
In the scenario above, you’d have total outstanding liens of $450,000 on a property currently worth $500,000.
The $50,000 difference would be your home equity, or actual ownership in the home.
The remainder is made up of loans, and one could argue that the bank is the one who owns that portion of the property since they could technically take it in the event of foreclosure.
Anyway, you could potentially tap into this home equity by refinancing your mortgage or taking out a home equity loan/HELOC.
However, it’s not always recommended because doing so increases your total loan balance and monthly mortgage payment.
It also means it’ll take that much longer to actually pay off your home loan(s), assuming that’s a personal financial goal.
Do You Have Equity in Your Home?
- First find out what your home is currently worth
- Then subtract any existing loan balances
- Lenders will also want you to have an equity cushion
- So you’re not borrowing every last dime in your home, which is risky
If you have high loan balances and your home isn’t worth much more than those outstanding liens, home equity financing may not even be an option for you.
The property acts as collateral for the loan, but if it’s already fully loaned out, there won’t be much left to tap into.
After all, you can’t borrow money if you have nothing to borrow from.
Additionally, you often need an equity cushion beyond what you’re able to borrow.
For example, mortgage lenders may allow you to tap equity up to 90% combined loan-to-value (CLTV), with the other 10% remaining untouched to ensure you have some skin in the game if home prices take a turn for the worse.
These maximum CLTVs will vary by bank and lender, and may also be dictated by current market conditions.
If the real estate market is strong, or lenders feel the need to adjust their risk appetites to garner more business, these limits may rise.
Conversely, if lenders are feeling particularly risk-averse, you might be limited to only 80% CLTV, meaning you won’t be able to touch a full 20% of your home equity.
During the early 2000s, borrowers could easily tap all 100% of their home equity, but that clearly didn’t go well.
