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How Big is Your Home Equity Cushion?
By JLP | February 25, 2006
I just read an interesting article called What We Own vs. What We Owe by Kenneth Harney of the Washington Post. The article talks about something called the home equity cushion, which is the amount of equity you have in your home divided by the amount you owe. Here’s how you calculate the ratio:
1. You paid $100,000 for your home 5 years ago. Your home now has a market value of $130,000.
2. You currently owe $90,000 on your home so your equity is $40,000 ($130,000 – $90,000 = $40,000)
3. Divide the amount of your equity by the amount still owed on the house to get your home equity cushion: $40,000 ÷ $90,000 = .444 or 44.4%.
According to the article, the person in this example is doing pretty good. The higher this number, the better because it represents a cushion that you can fall back on should you lose your job and have to sell your house.
One thing careful of is calculating the current market value of your home. If you think your home is worth more than it really is, your home equity cushion will be artificially high.
Topics: Mortgages, Net Worth Statement | 6 Comments »
February 26th, 2006 at 1:03 am
While this ratio might be useful for looking at macro trends, for an individual the actual dollar amount seems much more relevant. If I lose my job and have to sell my house, I care about how much cash I’ll get out of the deal.
I think a more useful ratio would be equity divided by living expenses. That would tell you how long you could survive on the proceeds from your house if you had to sell it.
I found the following two factoids interesting:
1) 80% of people with mortgages from 1985 have equity stakes of 75% – 80%. That’s not too exciting, but the fact that anyone has a mortgage from 1985 is — a 30 yr. mortgage from 1985 would be at around 14%! They need to refinance!
2) 30% of 2005’s borrowers have zero to negative 5 percent equity. Wow. That many low-quality borrowers is a pretty strong indication that the recent housing price increases are not sustainable.
February 26th, 2006 at 6:50 am
A good site to get an idea of the value of your home is zillow.com. I think it valued mine a little high, but using their data I’m sitting at 134%. Not bad!
February 26th, 2006 at 12:59 pm
Samewriter makes an excellent point re: the relevance of a dollar amount vs. a ratio. However his factoid #2 is confusing. It shouldn’t be surprising that mortgages written in 2005 should have a low debt to equity ratio and it doesn’t follow that those mortgagees are “low-quality.” With the low-rate environment that we had last year, it made sense to borrow as much as possible.
February 27th, 2006 at 11:53 pm
You’re correct that my point was not well made. It’s been my impression that generally mortgages without 20% down do not get the best rates, and often end up paying PMI, making them an unattractive proposition unless it’s the only way to get into a house. As the article states, it also makes the purchaser particularly vulnerable to any downturns.
Your objection is valid — I don’t _know_ that these are low-quality borrowers. I have only anecdotal evidence; when selling a relative’s house last year the realtor commented that these types of mortgages (i.e. 0% down, 40-year, etc..) were generally low-quality borrowers. Again anecdotally, friends of mine who have purchased with little down have done so because they couldn’t afford a larger downpayment.
March 10th, 2006 at 10:08 pm
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May 7th, 2008 at 12:52 pm
I think the most important step is to be realistic in what you can and cannot do. I’ve seen so many first time home buyers jump into something they cannot afford only because they have big dreams.
Do your homework done first if you are thinking about taking out a loan or mortgage. The time spent looking into your options can save you a good deal of money later on.