Quick! Let’s test your Jeopardy! knowledge.
Alex Trebek: “The portion of your home you own free and clear.”
If you guessed, “What is home equity?” you would be correct!
The entire promise of homeownership as a wealth vehicle rests on the concept of building equity. Equity is what separates the owners from the renters — it’s the whole reason you put up with leaky pipes and yard maintenance without a landlord on speed dial. And it’s the reason why when the day comes to sell your house, you have something to show for it.
From mid-2009 to 2019 the U.S. economy steadily expanded with rising home price growth and low unemployment, a trend that put more equity in the pockets of homeowners and downward pressure on the number of homes in negative equity.
The COVID-19 pandemic did create a temporary market slowdown in April 2020, but home prices have been preserved and even thrived due to record-low mortgage rates and inventory across the country. In fact, U.S. homeowners gained $9,800 at the end of Q2 2020, an increase of 6.6% year over year, according to a CoreLogic report. Not too shabby!
So let’s dig into calculating how much equity you have, how equity increases over time, and why you need to know where you stand before you sell your home.
Your basic home equity formula break down: How much of your house do you fully own?
Home equity is the market value of the property that you own, minus the amount you owe on your loan.
A quick way to get a ballpark figure for your home’s current market value is to use an online automated valuation model (AVM), such as HomeLight’s Home Value Estimator, to work with as you make your calculations.
However, while estimator tools can be a good starting point for understanding your home’s value, they aren’t exact. If you plan to sell your house soon, you’ll need to contact an agent to conduct a more accurate comparative market analysis that accounts for all the nuances such as upgrades and property location that can pull a home’s value down or up. If you’re looking into refinancing or a home equity loan, you may need to get an appraisal (even if it’s just a drive by version) to confirm the value.
Back to equity, though: The equity in your home starts with the down payment you put into it when you make the initial purchase. Then, over time, you build more and more equity as you pay down the principal balance of your loan while at the same time your property’s market value appreciates.
You can calculate your home equity with the following example formula for a home worth $500,000:
Current market value of home ($500,000)
Outstanding mortgage balance ($300,000)
Home equity ($200,000)
As you make mortgage payments every month, remember that some of that payment goes toward your principal balance and some of it goes toward interest. During the early days of paying your mortgage, that monthly payment covers just a small amount of principal (and is weighted heavily toward paying interest). But the slice that goes toward the principal gets bigger and bigger as you progress through the loan amortization schedule.
Your equity builds as you pay down the principal; however, note that the money you pay toward interest does not count as equity.
Bankrate, a popular personal finance website, offers a handy Amortization Calculator tool to help you see how much of your monthly mortgage is going toward interest versus principal based on the course of your loan term. You can also check the balances of your principal and interest on your monthly mortgage statements.
What’s the difference between home equity and your home sale proceeds?
So you’ve calculated your home equity and like what you see. You can’t wait to sell your house and pocket all that money that’s been tied up in the property. Cha-ching!
But wait… home equity is not the same thing as your net home sale proceeds — this calculation isn’t quite done for you.
When you calculate your equity in preparation of selling your house, you also need to factor in any expenses you’ll have to cover throughout the home sale to get a solid understanding of your financial picture. Sellers can expect to pay between 9%-10% of the final sale price on the following types of expenses:
- Home prep costs such as staging, upgrades, and repairs
- Agent commissions
- Transfer fees
- Outstanding taxes
- Additional closing costs
Two ways to build home equity: Price appreciation and mortgage payments
With all-cash purchases accounting for just 25.3% of home sales, the majority of home purchases are financed with loans. That means most homeowners are building equity over time in two different ways: by paying down their mortgage and allowing their house to enjoy the benefits of price appreciation over time.
Building equity in your home isn’t something that happens overnight. With most homeowners opting for 15 or 30-year mortgage terms, it takes time to pay down your loan balance. However, those opting for 15-year mortgage terms build equity faster with higher payments and lower interest rates, and therefore own their homes free and clear sooner.
Historically, home values increase over time, passively building the equity in your home. Data from the U.S. Federal Housing Finance Agency shows an upward trend in the house price index over the last five years.
As a general rule, home values appreciate over the long term but aren’t entirely recession-proof, as 2008’s subprime mortgage housing crisis affirms. Zooming in on the current market, Frank Nothaft, Chief Economist with CoreLogic forecasts a slowing of home price growth to 0.6% in July 2021, due to the inflated unemployment numbers throughout the 2020 COVID-19 pandemic.
If you’re curious to look at actual numbers, Aqua-Calc features a fun home value appreciation calculator. Plug in the year you purchased your home and the sales price, and then the long range date of sale and price to calculate your appreciation.
Want to build equity faster? Ask your lender if you qualify to remove private mortgage insurance (PMI)
If you purchased your home using a conventional loan and put down less than 20% of the purchase price, you’re likely paying for private mortgage insurance (PMI) in your monthly mortgage payment, which typically ranges from 0.5% to 1% of your loan amount annually. What many homeowners with conventional loans overlook is the fact that they can request to remove PMI once the principal balance of your mortgage drops to 80% of the original value of your loan.
Loan-to-value is the ratio between the value of your home loan and your home’s value. A lower loan-to-value ratio signifies to a lender that you are a lower-risk borrower.
Calculating your loan-to-value ratio is simple. Take your loan payoff balance (which includes interest) and divide it by your home’s appraised value.
Let’s walk through an example: If your house is worth $300,000 and you still owe $210,000, your LTV would be calculated like so:
Payoff balance ($210,000)
Home’s fair market value ($300,000)
Loan-to-value Ratio (0.7)
Your loan-to-value ratio is 70%; the higher the percentage, the higher the assumed risk by the lender, which is why mortgage insurance is required for loan-to-value ratios 80% and higher.
For more on determining whether you have enough equity to cancel PMI, consult our guide: Can I Cancel PMI if My Home Value Increases?
How much home equity is enough to sell the house?
The amount of equity you should have in your home before selling depends on your reason for selling. Danny Freeman, a top-selling real estate agent in Memphis, Tennessee, explains: “If someone’s relocating, you need 10% equity of the home — but if someone’s wanting to move up [in home size], I would say they probably need at least a minimum 15% equity versus their payoff to consider making a move. The more, the better.”
If your home’s sale price is enough to pay off your current mortgage and cover closing fees and commission without any out of pocket expenses, you have enough equity in your house to sell without owing any money at the time of sale.
“If your balance is $100,000,” says Freeman, “then you may actually owe when you go to sell at $101,500” — and that wouldn’t be fun!
If you’re selling to move into a larger home, you’ll want to use your equity to also take care of the down payment on a new home, or at least a portion of it.
Also note that equity is not the same as your home sale profit. The profit of your house is the difference between what you paid for it and what you receive at resale. Zacks Investment Research, a top independent resource of financial data and analysis for investors founded in 1978, provides an excellent example of calculating your home sale profits versus equity:
“Say you originally bought your home for $235,000, including a $50,000 down payment and a $185,000 mortgage,” the investment site explains. “Since then, you’ve paid the mortgage down to $150,000, and property values have risen in your area, so your home is now worth $250,000. Your equity is $100,000. But if you sell, your profit is only $15,000 — the increase in the value of your home.”
The rest that you receive is just getting the money back from that house that you already put into it.
How to use your home equity wisely
Now that you’ve calculated the amount of equity in your home, you may consider using your home equity in one of the following ways:
Roll it into your next home.
Many homeowners use the equity they’ve built to buy their next home. If you’re moving to a more substantial property, your equity can help you put a larger down payment on the house. If you’re downsizing, you’ll have cash in hand, perfect for investing, which leads to the second suggestion for using your home equity.
Use it to fund your retirement.
The most straightforward way to use your home equity for retirement is to downsize your home and invest the proceeds, but there are other options available. Reverse home mortgages can help supplement your retirement income while tapping into your existing home equity, but this option can make it difficult to leave your home to your children, among other risks. If you still need more ideas, here are five additional ways homeowners can use their home equity for retirement income.
Do a cash-out refinance.
Another option to explore is what’s called a cash-out refinance, whereby you refinance your home and the lender will advance you an additional amount in cash. You can then put this cash toward your remodeling costs or whatever you need it for. A lender will typically allow you to refinance 80%-90% of your home’s value. So, let’s say you have a home valued at $500,000 (which will likely need to be confirmed by an appraisal) and you only owe $300,000 on it. You could refinance for a $400,000 mortgage and take $100,000 as a cash-out to finance your project. What’s nice about this route is that a cash-out refinance is a standard first mortgage loan, not a secondary lien or line of credit.
Get a home equity loan or HELOC.
With a home equity loan or home equity line of credit (HELOC), you borrow money from a lender using the equity in your house as collateral. Typically, you’ll need at least 10% equity in your primary home (20% in an investment property or second home) to qualify for either option.
With the lump sum option, homeowners can borrow a chunk of money against their mortgage and repay it in installments with a fixed interest rate. The lump sum option can be preferable if fixed interest rates and a planned fixed payment time tables appeal to you. However, you should be aware that if you don’t repay the loan as promised, you could face foreclosure.
If having the ability to draw upon funds when needed appeals to you, opt for a HELOC. With a line of credit tapping into your home equity, you’re able to borrow money when needed, which is especially helpful with home improvement projects. However, HELOC interest rates fluctuate, which may cause your monthly payment to increase unexpectedly.
If you’ve not already calculated the amount of equity you have in your home, what are you waiting for? Contact a real estate agent for a comparative market analysis— or use our Home Value Estimator to get a rough idea of your home’s value. That way, you can start planning on how you’ll use what you’ve gained, whether you hope to renovate, retire, or upgrade your current home for a bigger, better option.
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