Before considering a home equity loan or line of credit, it’s important to understand the definition of home equity and what it means for your loan. In its simplest terms, equity is defined as the difference between the current value of your home and how much is left on your mortgage.
Let’s say your house has increased in value by $75,000 since you first bought it. If you haven’t paid any of your mortgage principal down (which you probably have unless you have an interest-only loan), this increase in value represents $75,000 which you can borrow against.
Similarly, if you have paid off $15,000 in principal from your mortgage, this is also home equity. Remember, however, that mortgage payments consist of both interest and principal and in the early years of your mortgage the monthly payments is mostly interest. So if you have not had your mortgage very long you may not have paid down as much principal as you might expect. Check your monthly mortgage statement to see how much principal has been paid.
So in this example, if the price of your home has increased by $75,000 and you have paid off $15,000 in mortgage principal, you have built up $90,000 in home equity. This is the definition of home equity in action.
However, that doesn’t mean you can go to a bank for a $90,000 loan. The amount you can borrow is determined by what is known as the “loan-to-value” ratio. The loan-to-value ratio tells you how much of your home equity you can tap into.
Since banks need to protect themselves, they won’t let you use all the equity you may have available in your house. Banks examine your annual income, credit rating, and the amount of your outstanding debt when determining how much to lend you. Most lenders won’t go higher than 80-85% of the appraised value of your house minus what’s left on your first mortgage.
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