Taking out a home equity loan can give you ready cash to make home improvements, consolidate debt or cover large expenses. Before applying for a loan, it is important to know how to calculate home equity to determine how much you may be able to borrow. It’s also good to understand how to calculate home equity loan costs so you know what you can afford. A financial advisor can help you figure out how a home equity loan works in your financial plan.
What is Home Equity Loan?
A home equity loan is a loan that is secured against the equity value of your home. Equity represents the difference between the amount you owe on the mortgage and the value of your home. A home equity loan is a type of second mortgage, where the home is used as security.
When you take a home equity loan, you can borrow up to the maximum amount set by your lender. The loan tenure can extend anywhere from 10 to 30 years and you will pay whatever is outstanding with interest.
Home equity loans typically have fixed interest rates, although they may be slightly higher than purchase loan mortgage rates. This is because a home equity loan presents more risk for the lender. Since this is a second mortgage, it is subject to the first mortgage on the home. If you fail to make payments on any loan, you could end up in default.
At that point, the lender can initiate foreclosure proceedings against you. This will give them the ownership rights of the house. The lender could then sell it to cover some of its financial loss.
How to Calculate Home Equity
Before applying for a home equity loan, you need to know how much equity you have. Home equity is simply the difference between what your home owes and what it’s worth. So if your home is worth $500,000 and you owe $350,000 on the mortgage, you’ll have $150,000 in home equity.
However, this number does not necessarily reflect how much you can borrow. Lenders use your loan-to-value (LTV) ratio to determine how much home equity loan you can qualify for.
How Much Can You Borrow With Home Equity Loan?
The debt to value ratio shows how much you owe on the home and what it is worth. Finding your home loan to value ratio involves a simple calculation and again, you will need to know two things:
To find your loan to value ratio, you would divide the current mortgage balance by the market value of the home, then multiply the result by 100. So, for example, if your home is valued at $500,000 and you owe $350,000 on the mortgage, you’d have a debt to value ratio of 70%.
This can be an acceptable LTV ratio for getting a home equity loan. Lenders typically set an upper limit on the loan to value ratio you can have for a home equity loan or home equity line of credit (HELOC). This upper limit is usually in the 70% to 80% range, although some lenders may raise or lower the limit.
Your LTV ratio affects how much of your home equity you can withdraw. So going back to the previous example, if you have 30% equity in your home based on your debt-to-value ratio calculation, you may be able to borrow up to $50,000 using a home equity loan. Using a simple online home equity calculator can be the easiest way to find out how much of a large home equity loan you may be eligible for.
How to Calculate Home Equity Loan Payments
There are many factors that affect what you will pay for a home equity loan. In general, your monthly payment may depend on:
- How much do you borrow? The larger your home equity loan amount, the higher your monthly payments are likely to be.
- loan term. A shorter repayment period can result in a larger payment while a longer term can lower your monthly payment.
- Rate of interest. The interest rate of a home equity loan can also affect payments, as a higher rate can mean paying more.
While choosing the terms for a home equity loan, there are a few things to keep in mind. First, choosing a shorter loan tenure will allow you to pay off the loan faster and potentially save you money on interest. But you’re likely to have higher monthly payments. That’s why it’s important to consider what you can realistically pay for a home equity loan on top of your regular monthly mortgage payment.
Second, a longer loan term can lower your monthly payments. This can be tempting if you’re concerned about being able to add both payments to your budget each month. But the longer the term of the loan, the more you are generally going to pay in interest overall.
Should I get a Home Equity Loan?
There are many reasons to consider a home equity loan if you need cash. For example, you may want to borrow money at a relatively low interest rate to pay:
- home improvement or renovation
- home repair
- debt consolidation
- college expenses
- wedding expenses
- medical expenses
- a new car or recreational vehicle
- business expenses
However, keep in mind that your home acts as security for the loan. If you are not able to balance both payments each month, you may risk losing the home to foreclosure.
Plus, see how much you can pay in interest and fees for a home equity loan. Like purchase loans, home equity loans also require you to pay closing costs, including appraisal and other fees. While your interest rate is fixed, it may be higher than the rate on your first mortgage.
Shopping with different home equity lenders to compare rates and fees can help you estimate the cost of borrowing. From there, you can figure out what your monthly payment is likely to be based on the interest rate and fees you pay.
Remember that a home equity loan is not your only borrowing option. You can also consider a personal loan with a lower interest rate instead. A personal loan offers the advantage of not being secured by your home, which reduces your default risk. And many personal loan lenders offer loans of up to $100,000, which can be ideal if you need to borrow a large amount but have a small amount of equity in your home.
Bottom-line
Calculating home equity is a simple yet useful skill if you are a homeowner. You can use this estimate as a springboard to determine how much you can borrow with a home equity loan or HELOC if you need cash.
Mortgage Planning Tips
- Apart from having sufficient equity in your home, there are a few other requirements that you need to meet in order to get a home equity loan. Lenders will look at your credit score, credit history, income, assets and debt-to-income (DTI) ratio. This ratio shows how much of your income goes towards loan repayment every month. If you’re considering a home equity loan or another mortgage loan, it can be helpful to review your credit report and score first to learn what lenders are likely to look for.
- Consider talking to your financial advisor about the pros and cons of a home equity loan and whether it might be right for you to apply for. Finding a qualified financial advisor should not be difficult. SmartAsset’s free tool matches you with three financial advisors who serve your area, and you can interview your advisor matches to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
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Rebecca Lake Rebecca Lake is a retirement, investment and estate planning expert who has been writing about personal finance for over a decade. His expertise in the finance sector also extends to home buying, credit cards, banking and small business. He has worked directly with several major financial and insurance brands including Citibank, Discover and AIG, and his writing has appeared online in US News & World Report, CreditCards.com, and Investopedia. Rebecca is a graduate of the University of South Carolina and also attended Charleston Southern University as a graduate student. Originally from Central Virginia, she now lives on the North Carolina coast with her two children.
