Debt-to-equity ratios can determine whether you can afford the house you want, or whether you can refinance the investment property you already own. It's a financial term, but it's also a measure of ownership: if the ratio is 60/40 of debt to equity, that means the bank owns 60 percent of the value of your home.
Equity and Debt
Equity is the value in your home -- or any piece of property -- greater than what you owe the bank. If your home is worth $220,000 and you owe $100,000 on your mortgage, your equity is $120,000. Your debt-to-equity ratio is 45/55, as your debt equals roughly 45 percent of your home's fair market value. Paying off the mortgage increases your equity. So does a good housing market: If your home's value rises by $30,000, so does your equity.
When you buy real estate, your down payment is all the equity you have in the property. The debt-to-equity ratio measures how much skin you have in the game: if your down payment is too small, lenders worry it's too easy for you to default and walk away. In 2011, for example, the national average down payment was 12.24 percent of the home price, giving buyers a ratio of 87.76 percent debt to 12.24 percent equity. Lenders writing federally backed mortgages may accept a down payment as low as 3.5 percent, or as high as 30 percent for an investment property.
If you've built up some equity in your home, you can borrow against it with a second mortgage -- also sometimes called a home equity loan -- or a home equity line of credit. To get a decent rate on the loan, you need a good debt-to-equity ratio. Typically, banks want to see at least 20 percent equity left after you take out the loan: On a $220,000 house with a $100,000 mortgage you could generally borrow up to $76,000 more without any problems.
A property is "underwater" when the debt-to-equity relationship goes negative. If the rental house you bought is now worth $140,000 and you owe $180,000 on the mortgage, you have a negative $40,000 in equity. The collapse of the housing market in the early 21st century left millions of properties suddenly worth less than the remaining mortgage. This isn't a problem if the owners can afford to hang on to the property long-term, but owners who have to move, or who bought houses intending to resell at a profit, have found themselves in serious trouble.
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- Second Home Mortgage Requirements
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- What Is a Second Trust Deed?
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