How to calculate home equity

What is home equity?

Home equity is the difference between your home's value and the amount you owe. Your home's value is somewhat subjective until you actually sell it. However, you can approximate its value by speaking with a real estate agent or looking online at sites like Zillow or Redfin.

Home values change over time based on various factors, including demand for homes in your neighborhood, interest rates, general market conditions and the economy.

The amount you owe includes all debt secured by your home. This includes your mortgage, a home equity loan or a home equity line of credit (HELOC), tax liens, and similar debt. Other debts, such as credit card, student loan and auto loan debt, don’t affect your home equity.

Having a large amount of equity in your home is a good thing. It can help you eliminate private mortgage insurance (PMI) and obtain lower interest rates and more favorable loan terms. It can also help to fund your retirement and reach other financial goals.

Your equity increases in two primary ways: as the home's value goes up and as you pay down your loans.

» COMPARE: Best Home Equity Loan Lenders

Steps for calculating your home equity

Calculating your home equity is essential to understanding your financial position and making informed decisions. If you want to calculate your home equity, follow these simple steps.

1) Determine your home's value

There are many ways to get an estimate of your home's value, and each one has a different level of cost and accuracy. Real estate websites estimate the value of homes based on recent sales, local trends and proprietary information.

Real estate agents can prepare a "comparative market analysis" for free or a small charge. Appraisals are the most accurate (and the most expensive) and may involve a thorough inspection of your home by an appraiser.

2) Add up debt secured by your home

Compile a list of all debts secured by your home. These debts may include your primary mortgage, home equity loan, home equity line of credit (HELOC), tax liens and other debts. Some business loans may have liens against your home or covenants requiring payoff if your home is sold.

3) Subtract debt from the home's value

Home equity is the difference between a home's value and the debt secured by it. For example, if your home is worth $450,000, and you have a primary mortgage of $305,000 and a HELOC with a $35,000 balance, your home equity is $110,000.

While many people don’t factor in closing costs in their home equity, a conservative approach includes these expenses to get a realistic idea of how much cash you'd receive if you sold your home. Typical selling expenses include a 6% real estate agent commission, seller concessions of 1.5% to 2% and closing costs of 1% to 3%.

Ways to use your home equity

As your home equity increases, there are numerous ways you can use that equity to improve your financial condition. These options include tapping your home equity, eliminating insurance requirements or qualifying for a mortgage with better terms or a lower interest rate.

HELOC

A HELOC is a line of credit with a variable interest rate secured by your home. Based on your equity, the bank's loan-to-value (LTV) limits and your finances, you'll receive a maximum credit limit you can borrow against.

Lenders typically allow HELOCs up to 80% to 85% of your home's value (including the amount on your current mortgage). As you draw from the HELOC and repay the balance, your equity adjusts accordingly.

Some homeowners obtain a HELOC for a specific borrowing need, while others get one for easy access to cash in an emergency. HELOCs are ideal for homeowners who want flexibility. Some allow borrowers to lock in a fixed rate on a portion of their outstanding balance. This converts that portion of the HELOC balance into a home equity loan with a defined repayment term.

HELOCs typically have a 10-year draw period where you can draw and pay down the balance repeatedly. During this time, you'll make interest-only payments based on the statement period's average balance and current interest rates.

When the draw period expires, the HELOC converts to an amortizing loan you can repay over a 20-year term.

Home equity loan

A home equity loan provides a lump sum of cash that you repay over several years. It usually has a fixed interest rate and loan payments that don’t change as the balance goes down.

As with a HELOC, banks typically allow LTV ratios up to 80% to 85% on home equity loans.

Since this loan is in second position behind your mortgage, the interest rate tends to be higher than on a traditional mortgage. Unlike with a HELOC, you can’t get additional cash from a home equity loan unless you obtain another loan.

Home equity loans are ideal for people who know exactly how much money they need and want a fixed monthly payment with a defined repayment term.

Cash-out refi

A cash-out refinance replaces your current mortgage with a new one with a higher balance. The new loan amount combines your existing mortgage plus the cash you're pulling out from your equity.

Some lenders also allow borrowers to add the refinance closing costs to their balance. When that option is available, borrowers can choose to pay the closing costs upfront or add them to their balance to pay over time.

The repayment term for a cash-out refinance resets the clock on paying off your home since it replaces your current mortgage. With this in mind, some homeowners refinance into a shorter term than a traditional 30-year mortgage.

The maximum cash-out allowable depends on your lender and the type of loan you're applying for. Lenders typically allow a cash-out refi with an LTV ratio of up to 80%.

Obtain a mortgage with better terms

Borrowers often get a mortgage with less desirable terms with the intention of refinancing once the home's value increases or their finances improve. The original loans may have high interest rates, include unfavorable terms or require both spouse's incomes to qualify.

As your home equity increases, you may qualify for better loans with more appealing interest rates and terms. Additionally, making the monthly payments on time may have increased your credit score. The minimum LTV ratio for these types of loans varies depending on the lender and the type of loan.

Eliminate PMI

When your mortgage balance is too close to the home's value, a lender may require you to have PMI on a conventional loan. Typically, conventional mortgages with LTV ratios higher than 80% require it. This insurance coverage protects the lender if you default on your loan.

As your home increases in value, you are able to eliminate the PMI when your LTV reaches 80%. This process is automatic when you've reached a 78% LTV ratio based on your home's original value. However, you can request removal of PMI once the LTV ratio drops to 80% of the original value of your home.

» MORE: How to get rid of PMI

How to increase your home equity

Real estate values tend to increase over long periods, and mortgage payments reduce your debt according to the loan's repayment schedule. These two factors increase home equity, but it can take a long time to see meaningful results.

Here’s how you can increase your home equity more quickly.

Extra mortgage payments

Each time you make an extra mortgage payment, you're accelerating the payoff of your loan. The additional payment amounts go directly to reducing your mortgage balance, which reduces the total interest you'll pay. Making one extra mortgage payment a year can knock off an average of four to five years off your loan term.

Lump sum against the principal

If you can access a larger amount of money, you may consider making a lump sum payment against your mortgage. This large payment will drastically reduce your mortgage balance and immediately boost your home equity. It will also reduce how much interest you owe every month to allow more of your monthly payment to go toward paying off the loan more quickly.

David Gavri, a real estate agent with Realty One Group in Las Vegas, says borrowers can use a lump sum to their advantage when buying a home. "You can increase your home equity from the start with a larger down payment and a smaller mortgage,” he said. “This will also lower your monthly mortgage payments and reduce interest costs."

Refinance to a mortgage with a shorter term

When you refinance your 30-year mortgage to a loan with a shorter term (like 10, 15 or 20 years), you'll pay off your loan faster. Even if you qualify for a lower interest rate, your monthly mortgage payment will typically increase because you're repaying the loan over a shorter period.

For homeowners who can qualify, this is an excellent strategy to reduce interest charges, accelerate mortgage payoff and grow home equity.

Improving the home to increase its value

Homeowners can boost their home equity by forcing appreciation of their house. Renovations, adding a room or replacing outdated decor can instantly grow a home's value. For every dollar your home increases in value, you'll receive an equal boost to your home equity. Popular home improvement projects include updating a kitchen, renovating the bathroom and adding a bedroom.

Steven Andrews, a real estate investor and the founder of SOARX Consulting, says you don't have to perform major renovations to improve a home's value. "Fresh paint, new light fixtures, updated countertops and a manicured landscape are just a few examples of ways to increase your home equity," he said.

» MORE: Home equity loan requirements

Bottom line

Calculating your home equity is an important step in managing your finances. This number helps you understand if you're on the right track for your goals. Knowing how much equity you have in your home opens the door to smart financial moves that can save money in the long run. Plus, it can provide access to money you need today for various reasons, including consolidating bills, starting a business, renovating your home or paying for a child's college education.