For the vast majority of Canadians, their primary residence is the largest investment they will ever make. Most mortgage holders pay their loans over a 30-year term, which means multiple loan renewals under Canadian law – and which also means slowly filling up a giant, house-sized savings account. As you pay off your mortgage, you build equity in your home as you pay off the principal.
However, you don’t build principal quickly, at least not at first, by making your monthly payments. The bulk of your payments in the first few years go to paying interest, with a small percentage going to pay off the principal. Over the life of the loan, the proportion going to principal gradually increases, but it takes several years to make a significant dent in your amount owed. If you want to start boosting your actual home equity, you need some additional strategies.
Calculating Home Equity
Your home equity is the actual number of dollars you own in your home. You can calculate your home equity by subtracting the amount you still owe on your mortgage principal from the current value of the property. Let’s say your most recent appraisal lists your home value at $700,000. When you bought the home, you paid $662,000, and your most recent mortgage statement lists the principal remaining due at $525,000. Subtracting that amount due from the value leaves an equity of $175,000. So in addition to the payments that you make on the loan, changes in property value also influence the amount of equity that you have. If you are thinking about taking out a home equity mortgage, then understanding how much equity you have is important. The same is true for construction mortgage loans.
Factors Influencing Home Equity
Obviously, making that monthly payment will increase your home equity over time. However, there are some factors that can work against you. Some of these include:
- Downward shifts in the housing market. Sometimes people sell their homes when the market is at a peak – but that means they also have to buy a new home at an artificially high price, unless they choose to rent until the market cools off. If you buy at a peak value and then the market corrects, your equity can drop, and even become negative if the market crashes.
- Taking out a home equity mortgage. Let’s go back to that example. Your home is worth $700,000, and you owe $525,000, leaving current equity at $175,000. Most lenders won’t let you take out the full $175,000 because if you go down to zero equity and then the market craters, you could have a serious negative equity issue. Lenders require you to maintain a loan-to-value ratio that builds in a cushion in case the market decreases – more about that below.
- High-interest, long-term loans. If you take out a subprime loan mortgage that has a lengthy term, you are initially making almost no progress on your principal because so much of your monthly payment goes to paying that interest expense. If you are having a difficult time getting funding from traditional lenders, then think about a private lender, who would provide a short-term loan, possibly interest-only, so that you can go ahead and move into the home you want and take the term of the loan (often no more than 12 months) to repair your credit so that you can get a traditional loan. If you’re wondering, “Do private money lenders require down payments?” the answer can vary, depending on the lender, your credit profile, and the value of the property.
However, the good news is that you can also build home equity more quickly. The fastest way is to make a larger down payment. If you want to avoid private mortgage insurance (PMI), then you normally need to make a down payment of at least 20%. If you can go beyond that, then you’ll have even more equity from the beginning. That way if you end up needing a home equity mortgage or a construction mortgage loan later on, you’ll have more equity to tap.
Another way to build equity quickly is to refinance to a shorter loan term. This means your payments will increase each month, but your total dollar amount paid will decrease because you are saving money on the interest end. Even if the interest rate remains the same, if you’re in your last mortgage renewal and can knock off a couple of years with a refinance, you save the interest you would have owed for the loan over those last months.
You can also pay the mortgage faster. If you think you’ll be doing this, then you will want to take out an open mortgage so that you are not penalized for making payments early. There are a few ways you can do this. If your monthly payment off the statement is $1200, and your mortgage is open, any dollars you add to that $1200 will go directly to paying off principal. A way to trick yourself into paying the mortgage off slightly faster is to make biweekly payments instead of monthly payments. If you pay $600 every two weeks, you would end paying $15,600 over the course of a year, but if you just pay $1200 per month, you would end up paying $14,400 over the same year. It’s not a huge jump, but every dollar adds up. If you encounter financial difficulties later on in the mortgage, then you can always drop down to the minimum payment – a much better solution than only paying the minimum to start and then having to choose between falling behind your mortgage and paying other bills.
The other two ways to boost home equity involve making home improvements and waiting for your house’s value to increase. Depending on the Alberta mortgage rates available to you for a home equity loan or a home equity line of credit (HELOC), you could easily find financing that will help you update your kitchen, renovate your master bathroom, make a second-story addition, or change your house in other ways that will boost the value over time. Real estate generally appreciates as time goes by, so even accounting for short-term dips in the market, you can expect that your home value will increase over the long term, making the investment in improvements worthwhile.
Loan-to-Value Ratio
As we mentioned earlier, your lender will require you to maintain a certain loan-to-value (LTV) ratio after you take out a home equity loan. No matter what Alberta mortgage rates you end up with, the required ratio will generally remain the same. Most lenders like the LTV to max out at 85 per cent or less, although with private lenders that number can be lower.
So if your home currently appraises at $500,000 and you owe $400,000, you already have an 80 per cent LTV, based on dividing your principal balance by your value. You would have a difficult time getting much in a home equity loan after closing costs and fees. If you have built equity to the point where you only owe $200,000, though, your LTV sits at 40 per cent. A total balance owed of $425,000 would put you at 85 per cent, so you will have a lot of options in terms of home equity financing.
In order to get the most accurate value, most lenders will require a professional appraisal as part of the due diligence with your loan application. The fee for this appraisal will be one of the costs associated with the loan process. The lender will arrange an appointment with a certified property appraiser to visit the property and estimate the value.
If your applications with traditional lenders, such as banks and credit unions, are getting rejected because of blips in your credit history, consider working with a private lender. As we mentioned earlier, a private lender can help you with financing for the first year or so while you get your credit score where it needs to be. Credit score still plays a role with private lenders, but they also understand that you are working to improve it, so they take the property value itself more into account than traditional lenders would. The idea is that you move your loan to a traditional lender at the end of the term, with your credit score where it needs to be. Don’t let that perfect house get away just because of a few dings to your credit score from five years ago.
Amansad Financial Services Inc, Brokerages and Financials Institutions that lend in the private lending space rely first on Equity and appropriate the Loan-to-Value Ratio, in addition to other elements of a loan request. However, if the equity or down payment is not adequate, other solutions may be available when you are looking are refinancing a Residential Property and even more so if it is a Principal residence. Commercial Properties that lack equity and do not meet traditional lending requirements have limited options. Contact Us to determine how we may be able to assist with your mortgage needs.