How Is a Home Equity Loan Calculated? - SmartAsset

Taking out a home equity loan could provide you with ready cash to make home improvements, consolidate debt or cover a large expense. Before applying for a loan, it’s important to know how to calculate home equity to determine how much you might be able to borrow. It’s also good to understand how to calculate home equity loan costs so you know what you might pay. A financial advisor can help you figure out how to work a home equity loan into your financial plan.

What Is a Home Equity Loan?

A home equity loan is a loan that’s secured by the equity value of your home. Equity represents the difference between what you owe on the mortgage and what your home is worth. A home equity loan is a type of second mortgage, where the home is used as security.

When you take out a home equity loan, you can borrow up to a maximum amount as determined by your lender. The loan term may extend anywhere from 10 to 30 years and you’ll pay back what you owe with interest.

Home equity loans typically have fixed interest rates, though they may be slightly higher than purchase loan mortgage rates. That’s because a home equity loan presents a greater risk to the lender. Since this is a second mortgage, it’s subordinate to the first mortgage on the home. If you fail to keep up with the payments on either loan, you may end up in default.

At that point, the lender could initiate foreclosure proceedings against you. This would allow them to take ownership of the home. The lender could then sell it to recoup some of their financial losses.

How to Calculate Home Equity

Before you can apply for a home equity loan, you need to know how much equity you have. Home equity is simply the difference between what you owe on the home and what it’s worth. So if your home is worth $500,000 and you owe $350,000 on the mortgage, you’d have $150,000 in home equity.

This number doesn’t necessarily represent how much you can borrow, however. Lenders use your loan to value (LTV) ratio to determine how much of a home equity loan you might qualify for.

How Much Can You Borrow With a Home Equity Loan?

The loan to value ratio represents how much you owe on the home versus what it’s worth. Finding your home’s loan to value ratio involves a simple calculation and again, you’ll need to know two things:

Your current mortgage balance
The current market value of your home

To find your loan to value ratio, you’d divide the current mortgage balance by the home’s market value, then multiply the result by 100. So, for example, if your home is worth $500,000 and you owe $350,000 on the mortgage, you’d have a loan to value ratio of 70%.

This could be an acceptable LTV ratio for getting a home equity loan. Lenders generally set an upper limit on the loan to value ratio you can have for a home equity loan or a home equity line of credit (HELOC). This upper limit is typically in the 70% to 80% range, though some lenders may move the threshold higher or lower.

Your LTV ratio influences how much of your home equity you can withdraw. So going back to the previous example, if you have 30% equity in the home based on your loan 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 may be the easiest way to get an idea of how large a home equity loan you might qualify for.

How to Calculate Home Equity Loan Payments

There are several factors that influence what you’ll pay for a home equity loan. Generally, your monthly payments can depend on:

How much you borrow. The larger your home equity loan amount, the larger your monthly payments are likely to be.
Loan term. A shorter repayment term can result in a larger payment while a longer term can lower your monthly payment.
Interest rate. The home equity loan’s interest rate can also influence the payment, as a higher rate may mean paying more.

When choosing terms for a home equity loan, there are a couple of things to keep in mind. First, choosing a shorter loan term will allow you to pay the loan off faster and potentially save you money on interest. But you’ll likely have a higher monthly payment. So it’s important to consider what you can realistically afford to pay toward a home equity loan on top of your regular monthly mortgage payment.

Second, a longer loan term could reduce your monthly payment. That might be attractive if you’re concerned about being able to add both payments into your budget each month. But the longer the loan term is, the more you’re typically going to pay in interest overall.

Should I Get a Home Equity Loan?

There are lots of reasons why you might 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 for:

Home improvements or renovations
Home repairs
Debt consolidation
College expenses
Wedding expenses
Medical expenses
A new car or recreational vehicle
Business expenses

Keep in mind, however, that your home acts as security for the loan. If you’re not able to balance both payments each month, you could risk losing the home to foreclosure.

Aside from that, look at how much you might pay in interest and fees for a home equity loan. Like purchase loans, home equity loans also require you to pay closing costs, including an appraisal and other fees. While your interest rate is fixed, it may be higher than the rate on your first mortgage.

Shopping around with different home equity lenders to compare rates and fees can help you estimate the cost of borrowing. From there, you can work out what your monthly payments are likely to be, based on the interest rate and fees you expect to pay.

Remember that a home equity loan isn’t your only borrowing option. You could also consider a low interest rate personal loan instead. A personal loan offers the advantage of not being secured by your home, which lessens your default risk. And many personal loan lenders offer loans up to $100,000, which could be ideal if you need to borrow a larger amount but have a smaller amount of equity in your home.

The Bottom Line

Knowing how to calculate home equity is a simple but useful skill if you’re a homeowner. You can use this estimate as a springboard for determining how much you might be able to borrow with a home equity loan or HELOC if you need cash.

Mortgage Planning Tips

In addition to having sufficient equity in your home, there are some other requirements you’ll need to meet to get a home equity loan. Lenders will look at your credit scores, credit history, income, assets and debt-to-income (DTI) ratio. This ratio represents how much of your income goes toward debt repayment each month. If you’re considering a home equity loan or any other mortgage loan, it may be helpful to review your credit reports and scores first to get a feel for what lenders are likely to see.
Consider talking to your financial advisor about the pros and cons of home equity loans and whether applying for one may be right for you. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.