Home equity is the difference between your home’s value and your existing mortgage balance.
When you have equity in your property, it means you have an ownership claim on some or all its value.
Should you sell it, the cash proceeds left after you pay off your remaining mortgage principal belong to you.
How To Calculate Home Equity
Determining your home equity is straightforward.
Suppose the fair market value of your property is $585,000, and you have a balance of $225,000 left on your mortgage.
To figure out your home equity, simply subtract your mortgage from your property’s value, which works out to be $360,000
Your home equity can increase in two ways.
The first way is through your regular mortgage payments (and sometimes, prepayments).
With each payment you make, you reduce a portion of your principal, thereby gradually realizing more home equity over time.
The second way is through appreciation of the value of your home, which occurs organically based on factors outside of your control.
These include an expanding economy and strong housing demand in your area.
However, the market can also be detrimental to your home’s equity.
For example, during a recession, housing demand typically declines, sometimes substantially, which can depress your property’s value.
If your home’s value dips below your loan principal, your equity turns negative (sometimes called an underwater mortgage), which increases the risk of your lender initiating a foreclosure.
Fact
37% of American subprime borrowers who purchased a home in 2007 had negative home equity by mid-2009 due to the financial crisis of 2007-2008 that ravaged the housing market.
Refinancing Your Home
A cash-out refinance allows you to tap into the equity you’ve built up in your home.
The process entails paying out your current mortgage, getting a new larger mortgage and receiving the difference in cash.
For example, let’s say your home is worth $800,000 and has a $350,000 mortgage on it.
You refinance your home, with a new mortgage amount of $560,000.
What this means is that your lender will deposit the excess $210,000 ($560,000 – $350,000) as a lump sum in your bank account for you to use at your discretion.
Of course, you’ll need to repay the entire principal of $560,000 through regular payments.
In Canada, you can refinance to borrow up to 80% of your home’s value, less your current mortgage balance.
You must also deduct any other loans for which your home acts as collateral, including a HELOC.
An example will help illustrate this point.
Suppose you appraise your home’s value at $600,000, and your existing mortgage amounts to $210,000.
This means that your loan-to-value ratio (LTV) is 35% ($210,000 / $600,000).
As a result, the maximum additional amount you can borrow through refinancing is $270,000 ($600,000 x (80% – 35%)).
Getting a Home Equity Line of Credit (HELOC)
A HELOC functions like a standard line of credit in that you can draw money as needed up to a pre-set credit limit.
As you pay down your principal, those funds become available for you to use again.
What makes a HELOC unique is that your home acts as collateral to secure the funds you borrow.
As with a cash-out refinance, lenders typically offer this credit product to borrowers with a minimum of 20% equity in their property (some ask for 25% or more).
As a standalone product, the maximum amount you can draw through a HELOC is 65% of your home’s market value.
However, if you combine your HELOC with your remaining mortgage balance, your borrowing power rises to 80%.
A notable characteristic of HELOCs is that they come with variable interest rates.
As a result, the rate your lender initially assigned to you will fluctuate as rates in the broader economy shift up or down.
Considerations Before Using Your Home’s Equity
Before tapping into your home’s equity, ensure you carefully consider both the benefits and drawbacks of doing so.
Access to Low Interest Rates
By leveraging your home equity, you can obtain financing at a lower rate compared with an unsecured loan or credit card.
The reason is that your home acts as collateral, so the lender assumes less risk in extending credit to you.
Great Flexibility
With a cash-out refinance, you have the freedom to spend your borrowed funds as you wish.
You can consolidate your high-interest debt, pay off past-due bills, cover vacation expenses, enhance your investment portfolio, and more.
If you opt for a HELOC, you enjoy even greater flexibility.
Instead of receiving a lump sum of cash upfront from your lender, you can borrow strictly the amount you need, as you need it.
Strict Eligibility Criteria
Refinancing your property requires a new mortgage, which means you must requalify for financing again.
And this time around, your lender may impose higher standards, given that you’re applying for a larger loan.
Typically, you’ll need to satisfy the following requirements:
- Possess a high credit score (usually higher than 650)
- Provide proof of income
- Pass the mortgage stress test
- Have reasonable gross debt service and total debt service ratios (usually between 39% and 44%)
Potentially More Expensive
Having the privilege of extracting cash out of your home doesn’t come without a cost.
You may have to cover various administrative fees levied by your lender.
These include
- Title search fees
- Home appraisal fees
- Title insurance
- Legal fees
- Discharge fees (if moving your mortgage to a new lender)
In addition, you may end up with a higher interest rate than you currently have.
If you choose the HELOC route, you also face the possibility of higher interest costs should market rates rise, given that it’s a variable-rate product.
Don’t Forget!
If you choose to refinance your mortgage before your term’s expiry date, you may have to pay a prepayment penalty.
Frequently Asked Questions
- How much equity can I take out of my house in Canada?
- What does it mean when you have equity in your home?
- What happens to the equity in my house when I sell?
