Home Equity 101
The longer you live in your home, the more it becomes your own. That’s true in both the figurative sense, as you fill the home with family and memories and you make the space your own, but also literally, as your equity in your home increases while you pay your mortgage over the years.
How much of your home is yours?
Simply stated, home equity is the amount of your home that you own free and clear. Your equity is represented in a loan-to-value ratio, or LTV. This is calculated as the remaining balance on your loan compared to the appraised value of your home. Your equity builds over time as you pay down the principal of your mortgage. As your home value increases, this will drive your LTV even lower.
For example, if you still owe $300,000 on your loan but your home’s worth $650,000, your LTV is 46%. But if you keep paying down your loan until you owe $250,000 and your home’s appraised value rises to $750,000, your new LTV will be 33.3%.
Lending institutions prefer a lower LTV because they consider those loans to be less risky. The average LTV in the US is 55.5% as of May 2020.1
2020 trends in home equity
The housing market over the last year, fueled by low rates and low inventory of homes for sale, has driven home values up and brought LTVs down.2
Tappable home equity, meaning the homeowners’ equity with an LTV of 80% or lower, rose to a record $6.5 trillion in the first quarter of 2020, according to mortgage software and analytic firm Black Knight in a report released this summer. That is 8% higher than it was during the first quarter of 2019 and nearly twice the level it was in 2013.3
More than 75% of homeowners with tappable equity have interest rates above 3.5%, the report said.3 That suggests that they could save on their monthly mortgage payments with a refinance to today’s historically low mortgage rates, perhaps hundreds a month.4
Beyond refinancing, here are some other ways that you can tap into the equity of your home.
HELOC turns your home into a credit card
A home equity line of credit works similarly to a credit card. Also called a HELOC, it allows you to borrow money using the equity of your home as collateral. You may borrow as much as you want, up to your credit limit, and have that money available to you over a set period of time.
It offers revolving credit just like a credit card, meaning you can borrow, for example, $5,000 of a $12,000 limit. Then if you paid back $4,000, you’d have $11,000 of credit remaining. Your credit limit and initial interest rate on this loan depend on your credit score, the length of the HELOC and your LTV.5
What’s a HEL?
A helpful way to think about a home equity loan (HEL) is as a second mortgage. You’ll receive a lump sum when you get the loan, and you’ll have to pay it back at a fixed interest rate over a fixed period of time. Usually, home equity loans are paid back over 10 or 15 years.
You’ll be responsible for monthly payments over the life of the loan. The interest rate on these loans tend to be higher than the rate on your primary mortgage but are lower than what you’d find on a credit card, for example.
Cash-out your equity
A cash-out refinance is an entirely new mortgage, replacing your old loan with a new one for a larger sum than you currently owe. The difference between your old mortgage and new one is the amount of money you’ll receive in one lump sum at closing – the “cash out” from the name.
The amount of cash you can take out depends on your LTV. Your lender will determine 80% of your home’s value, so in the example above 80% of $750,000 is $600,000. This is known as your max LTV. Subtract the $250,000 you still owe, and the most you could cash out in this example is $350,000, minus closing costs.6
All three of these are powerful instruments for putting the equity you have in your home to use. A loan officer can help you decide which of these would work best for you depending on your situation, your credit and what you’d like to accomplish with your equity.
1 https://www.statista.com/statistics/460677/average-ltv-in-the-usa-by-state/
2 https://themortgagereports.com/70539/record-high-prices-record-low-mortgage-rates-during-covid
3 Savings, if any, vary based on consumer’s credit profile, interest rate availability, and other factors. Contact Guaranteed Rate Affinity, LLC. for current rates. Restrictions apply.
4 https://www.housingwire.com/articles/tappable-home-equity-rises-to-record-6-5-trillion/
6 https://themortgagereports.com/18286/cash-out-refinance-mortgage-freddie-mac