What does equity mean in a home?
Let's begin by understanding what equity means in a home. Equity is the value you build up over time in your home.
First, your home would need an appraisal. You want an accurate measure of your property value. The equity is the difference between the appraised value of the home and how much is still owed in a mortgage.
For example, let's say your home appraises at $270,000. The balance due on your mortgage is $140,000. This means you have $130,000 in equity in your home.
Another way to think about the equity in your home is that it's the part of your home that you already own.
How much equity can you borrow from your home?
Now that you understand equity, you might be wondering if you can actually borrow all the equity you've built up in your home. It would seem like since you have created it, shouldn't you be able to access all of it? The quick answer is no, you can't borrow the whole amount.
Remember, if you want to borrow the equity in your home, you'll need to visit a lender to gain access to those funds. More on your options for how to do this later.
The lender won't allow you to borrow the entire amount of equity. Most lenders will only allow you to borrow up to 85% of the equity you have built up. This number varies from lender to lender.
Let's talk about how you know what percentage you can borrow.
The lender will use a term called the loan-to-value ratio. They will use the loan-to-value ratio to decide on the amount of equity you're able to borrow.
Here's how you calculate your loan-to-value ratio. Again, you need to know those two important numbers, how much you still owe on your mortgage and what your house appraises for.
Take your balance owed and divide by the appraisal value to get a percentage. This percentage is the loan-to-value ratio.
Let's use the previous example where the mortgage still had $130,000 owed on the home worth $270,000. Here, you would divide the $130,00 by the $270,000 to get a loan-to-value ratio of around 48%. This means you have 52% of the equity in the home and a lender would surely think you could access the equity in the home.
This still doesn't mean you can access all of that equity. No lender will allow you to take every bit of equity from your home. This is where you need to know their loan-to-value ratio requirements. Say the lender has a loan-to-value ratio of 80%. In the above scenario, and with the right credit score, you could borrow 80% of $140,000 of equity you have or up to $112,000.
Remember, that the loan-to-value ratio number varies from lender to lender.
What other factors will impact accessing equity?
Anytime you apply for a loan, even if you're borrowing against your own equity, the lender will consider what kind of lending risk you are to them. They are still giving you money and have some risk. Let's take a look at what factors a lender will consider when you apply to access the equity in your home through either a home equity loan or home equity line of credit.
Just like when you apply for a mortgage, your credit score and credit history will be a big factor. You will pay interest on the money you borrow. So, the better your credit score, the better the interest rate you'll get from the lender.
Again, requirements will vary from lender to lender. But most lenders will want a credit score in the mid 600s. Some will even require a minimum score of 680 to be eligible for a home equity loan. To get the best interest rate on your loan, a credit score above 700 would be best.
If you're considering applying for a home equity loan in an effort to get access to the equity in your home, you want to take a look at your credit score. Before applying and being declined, or getting approved with a higher than the needed interest rate, take the time to work on improving your credit score.
Pay down your debt, make sure you're paying your bills on time, and don't apply for any new accounts. These are just some of the ways you can work to improve your credit score.
This has already been covered. But before looking at you as a candidate for the loan, the lender will look at the property. They want the loan-to-value ratio to be at or below 80%. Or put another way, the lender will want you to have a minimum of 20% available equity in the home.
Another consideration for the lender will be your debt-to-income ratio. This is basically how much debt you must pay out each month in bills compared to your total gross monthly income. Gross monthly income is how much money you make before any deductions like taxes or insurance are taken out of your money earned.
To calculate this number add up your total gross monthly income. Then add up all the debts you pay each month. Divide your total gross income into your total debts to get the debt-to-income ratio.
This percentage tells a lender how capable you will be to afford to pay back another debt like a home equity loan. The magic percentage here is 43%. Lenders will usually not loan to an applicant who has a debt-to-income ratio above 43%.
This is another time when you want to do your homework before applying for a loan only to be declined. If you work to pay down some debt, you can improve not only your credit score but also your debt-to-income ratio percentage.
Employment and credit history
The lender will also consider your ability to repay a loan. They want to see you have the appropriate income coming in that you could afford the additional payment. They will also consider how well you have done making payments on time in the past.
Be prepared to explain what your intentions are for the money you're borrowing. The lender is likely to ask why you wish to access this money.
What options do you have to access equity in your home?
Now you understand how to calculate how much equity you can access and even how to tell if you're a good candidate to get it. What options are available to you to borrow on your built-up equity? Let's take a closer look at the options you might want to consider.
Home equity loan
A home equity loan is a lump sum loan amount. You're using the available equity in your home as collateral to gain access to the loan. You decide how much you want to borrow and it's paid in one sum to you.
The terms are similar to a regular mortgage. There is:
- A fixed amount, to borrow that comes in a lump sum.
- A fixed interest rate on the borrowed amount.
The borrower repays this amount back over a set period of time. This time period is usually a much shorter time period than a regular mortgage though.
For most borrowers, even those with good credit, the home equity loan has a slightly higher interest rate than a regular mortgage. If the borrower were to foreclose, the original mortgage borrower would get paid back first from the home sale before the home equity lender. This means the home equity loan lender is taking on a little more risk since they're second in line.
Home equity line of credit
Another option is called a home equity line of credit or a HELOC. Like a home equity loan, you're accessing equity from the home. In this case, the HELOC is a line of credit that you access when you need funds. Instead of it being paid in one lump sum like a home equity loan, you access it as you need it.
A home equity line of credit will have a revolving balance like a credit card does because you'll access money as needed and continue to make payments toward the balance.
Most HELOC loans are structured in two parts. For a set period of time, you can access the equity as needed, then during the second part, you can no longer access funds and instead are just paying off the borrowed equity.
A cash-out refinance is another way to access equity but it works a little differently than the other options. It's like getting a brand new mortgage to replace your existing one.
In this case, you borrow more than is owed on the house. You might still owe $80,000 on the mortgage. But with a cash-out refinance you borrow $110,000. The first $80,000 pays off what is owed and the remaining $30,000 is paid to the borrower in cash.
This is another option available to access the equity in a home but it's only available to homeowners who are 62 or older. A senior might get a reverse mortgage on their home to access funds from the equity they've built up over time.
In a reverse mortgage, a borrower can get the funds:
- In tax-free cash in a lump sum.
- Via monthly payouts.
- Or as a line of credit.
Reverse mortgages have many rules for both borrowing and repayment. They are also very expensive for the borrower. If you are eligible and want to consider a reverse mortgage, you should do your due diligence and read the fine print carefully.
Considering a home equity loan
The most common way to access home equity is either through a home equity loan or a home equity line of credit. Let's take a closer look at the pros and cons of these options.
Pros of a home equity loan
There are some real benefits to going with a home equity loan. A home equity loan comes with a fixed interest rate so the payment remains steady during the life of the loan. Even if interest rates fluctuate, your loan payment won't change.
Home equity loans are really a pretty reasonable way to borrow money. Often you can get a much lower rate on a home equity loan than you can get from a credit card or a personal loan. Again, because your home is part of the equity, the bank is able to take the risk and offer a loan at a lower interest rate than those other options.
Certainly, it's advisable to use the money you get wisely and to have a plan for it. You don't want to borrow it just to have access to cash. Yet, one of the advantages is that once you get your lump sum of money, you can use it how you see fit.
Depending on how you use the money, you may also be able to write off the interest from the home equity loan on your taxes. For example, if you use the money from the loan to make home improvements, you can write off the interest.
Cons of a home equity loan
The interest rates, while better than some options, are often higher from a home equity loan than they would be for a home equity line of credit. Because the rate is fixed, it tends to be higher than a HELOC rate.
While using the equity in your house allows you to get the loan, you are still using the home as collateral. This means if for any reason you stopped making the payments you could be foreclosed on and forced out of the house.
Home equity loans are like mortgages so you will also pay closing costs for the loan. You should factor this into costs when deciding on the best option for you. Some lenders will allow you to wrap the closing costs into the actual loan. And because it's like a mortgage, you'll have two mortgage payments to make each month.
Pros of a home equity line of credit
Interest rates are at all time lows and HELOCs have lower interest rates traditionally than your other options. This means you can get a loan at a very good rate with a decent credit score.
Like a home equity loan, if you use the money for home improvements you can write off the interest on your taxes.
Another benefit to a HELOC is that you borrow only the amount you need, when you need it. You can set up a home equity line of credit and only access the funds when you need to.
Finally, another benefit to a home equity line of credit is the options you will have for how the loan is structured. Depending on the lender you use and their terms, your options for interest and life of the loan can vary.
Many borrowers also appreciate the flexibility that a HELOC offers. While it is equity from your home that the funds come from, you're not limited to using the money for just that purpose. You can access the funds for education or travel or other expenses even.
Cons of a home equity line of credit
A home equity line of credit comes with a variable interest rate. While the rate is often lower than a home equity loan, it's still not a fixed rate. This means if the market takes a turn for the worse, your payment could increase.
For some the option to access funds with ease means they could risk overspending. Just knowing you have money could mean there's a risk over spending or spending for the wrong reasons.
Like a home equity loan, the collateral for the HELOC is your home which again puts it at risk if for some reason you're unable to make payments.
It's also important to remember that each time you take money out from your HELOC, you're reducing the amount of equity you have left in your home.
Wealth or liquidity?
As you consider whether accessing home equity is a good idea for you, it's important to remember where the money comes from. Borrowing against the equity in your home may provide you some cash flow. Yet, it's important to remember that money shouldn't be classified as wealth.
Many people spend much of their adult lives working to pay off a house so they have the equity as a senior citizen. If you access equity, you are really just transferring assets. You're making the assets held in your house liquid.
There's some risk in spending your equity if you don't remember this concept.
Increasing equity in your home
Are you looking for ways to increase the equity in your home? Maybe you don't have enough equity built up in your home to make a home equity loan or home equity line of credit feasible or worth it.
How can you build up equity more quickly in your home?
The most obvious way is when you pay your mortgage payment each month. Every time you make a payment you increase your equity, even if it's by a small amount. If you can extra on your mortgage each month, then your equity will grow even more quickly.
When you're able to make home improvements to your home, you could be adding value to the home. When the value increases, you're increasing your equity overall. Make sure when you consider home improvements that you do some research on what gives you the best return on investment.
Real estate is almost always a sound investment and property values increase over time. As property values increase and you owe less, your equity increases too.
If you're just in the process of buying a home, know that any money you use as a down payment becomes equity in your home. So, the larger your down payment, the more equity is sitting in your home.
Understanding how to pull equity out of your home
Buying a home is a huge step for so many people and one that fulfills the goals of homeownership. It allows you to make those monthly payments on the home knowing you acquiring equity in the home until you own it outright.
One of the benefits of growing the equity in your home is being able to access it when you might need it. It's good for you as a homeowner to know how to pull equity out of your home when you need it. Knowing the different ways to access that equity gives you the power to make the best decision if you want to borrow the equity from your home.
Wondering what your home is actually worth? If you're ready to sell your home, we can help with that too. Use our home iValuation calculator to see what your home is worth and how to sell it quickly using our network.