Home equity is the value of a homeowner’s unencumbered ownership interest in the property that is their home. Another way of expressing home equity is to say that it’s the portion of your home’s market value that is free and clear of your mortgage loan obligation.
Home equity is calculated as the fair market value of the home, minus the outstanding unpaid balance owed on the property’s mortgage loan, and the total of any other liens on the property. A lien is any debt interest in a property that requires that it be paid off in order to sell the property. A common example of a lien on real property is a tax lien.
Home equity is an important concept for homeowners to understand, as it represents the amount of cash that they will receive free and clear when they sell their home. It is the amount of money that remains after the homeowner pays off their mortgage obligation, along with any other debts that encumber the property.
Home equity refers to the monetary value of a homeowner’s unencumbered ownership interest in their property.
The primary determinant of the value of your home equity interest is the current fair market value of your home.
Homeowners may use a home equity loan or line of credit to access the cash value of their home equity.
Understanding Your Home Equity
It’s important for you, as a homeowner, to clearly understand exactly what your home equity is. Many homeowners mistakenly believe that their home equity is equal to the amount of money that they’ve already paid off on their mortgage loan.
In other words, they believe that the amount of their equity on a home they paid $200,000 for is equal to their purchase price – what they paid for their home minus the amount of the remaining principal balance of their mortgage loan that they’ve already paid off. That formula would be as follows:
Home Equity = PP – (RP + OL)
PP is the purchase price the homeowner paid for the home when they bought it.
RP is the “remaining principal” balance of the mortgage loan that the homeowner still owes.
OL stands for the amount of “other liens” on the property that may exist (such as property tax liens or child support liens).
However, the formula rendered above does not provide an accurate calculation of a homeowner’s equity, as it is based on an incorrect understanding of what home equity actually is. The key determinant for calculating your home equity is not the price you paid for your home when you bought it, but rather the selling price that you could obtain when you go to sell your home – your home’s current fair market value.
The dollar amount you can reasonably expect to get when you sell your home is the proper figure from which the remaining principal balance still owed on your mortgage loan should be subtracted.
Therefore, the correct formula for calculating your home equity is the following:
Home Equity = FMV – (RP + OL)
FMV is the current “fair market value” (commonly determined as the appraisal value) of your home.
RP is the “remaining principal” amount of the mortgage loan, the principal balance that has not yet been paid by the borrower (the homeowner).
OL stands for any “other liens” on the property that may exist.
Fair Market Value is Usually to Your Advantage
The current fair market value of your home is likely to vary substantially from the price you paid when you bought the home, and the variation is usually in your favor. It is because real estate values typically rise over time, so that most homeowners when they go to sell their home, find that they can realize a profit because they can sell their home for a higher price than what they paid for it.
Of course, there is a possibility that the fair market value of your home may be less, rather than more, than what you paid for it. It was the situation confronting many homeowners following the housing market crash in the Global Financial Crisis of 2008. Because of the significant fall in real estate values, a homeowner might’ve faced the problem of wanting to sell a home that they’d paid $300,000 for, but whose current fair market value was only $180,000.
In addition, they might have still owed, for example, $200,000 on their mortgage loan. Therefore, selling their home at its current fair market price would leave the homeowner $20,000 short of being able to pay off their outstanding mortgage loan. Such a situation is described as being “underwater” or “upside-down” in terms of your home’s value in relation to your mortgage loan.
Consider the example below to better understand what home equity is.
Assume that the homeowner, Aurora, bought her current home for a price of $220,000 eight years ago. When she bought the home, she made a down payment of $35,000 and financed with a 15-year mortgage loan the balance of the purchase price – $185,000. The remaining principal balance owed on her mortgage loan is $110,000.
Note that although Aurora is slightly past the halfway point on her 15-year mortgage loan, she still owes more than half of the loan’s principal amount of $185,000. It is because of the way mortgage loans are structured, with more money from each loan payment going toward paying off the total interest due on the loan, rather than to retiring the principal amount during the earlier part of the loan term. As the loan term passes, progressively more of each mortgage payment goes to paying off the principal and progressively less toward paying the interest on the loan.
When you take out a mortgage loan, your lender will provide you with a loan amortization schedule that will show you, month to month, from one loan payment to the next, how much of each loan payment is going toward paying off the principal and how much toward paying the interest on the loan, and what the remaining principal balance due on your loan is after each loan payment is made.
An appraiser determines that Aurora’s home now carries a fair market value of $280,000. Using the formula delineated above, we can determine Aurora’s home equity as follows:
Home Equity = $280,000 – $110,000 = $170,000 (assuming there are no other debt encumbrances on the property)
Note that the value of Aurora’s home equity is considerably more than what she would’ve thought it to be if she incorrectly used her purchase price in the past, rather than the home’s current fair market value, as the basis for calculating the value of her equity.
Her purchase price of $220,000, minus the outstanding principal amount of $110,000, would incorrectly indicate her home equity value as only being $110,000 ($220,000 – $110,000 = $110,000).
Home Equity as a Financial Asset
As a financial asset, home equity is considered one of the most solid of personal assets. Its value is secured by the property and verified by appraisal and sales records.
However, it is not a very liquid asset, since it can’t be quickly converted into cash. In order to access financial liquidity, many homeowners either take out a loan against their equity – known, predictably enough, as a home equity loan – or establish a home equity line of credit (usually referred to by the acronym, “HELOC”).
A HELOC is a line of credit secured by the homeowner’s equity interest in their home. Based on the monetary value of the homeowner’s equity, a lender will establish a line of credit for the homeowner. The homeowner can then access funds, as needed, up to a maximum amount that is correlated to the dollar value of their home equity.