How to take equity out of your home

If you’re a homeowner, you may have noticed the significant increase in your home’s equity in recent years. The surge in home prices, fueled initially by the pandemic and now by housing inventory shortages, has resulted in a rise of $806 billion in homeowners’ equity stakes during the second quarter of 2023. That’s an average increase of $13,900 per homeowner, as reported by CoreLogic’s “Q2 2023 Homeowner Equity Insights” report.

Taking advantage of this equity can be a cost-effective way to borrow money compared to credit cards or other forms of financing. In this article, we’ll explore the basics of how to tap into your home’s equity and the different options available to you.

Ways to Take Equity Out of Your Home

There are three common ways to convert your home equity into cash: a home equity loan, a home equity line of credit (HELOC), and a cash-out refinance.

Home Equity Loan

A home equity loan is a fixed-term loan with a fixed interest rate that is repaid over a set period (usually 20 years). It functions similarly to a mortgage and is considered a type of second mortgage. The loan is secured by your home or, more precisely, your equity in your home.

Home equity loans typically have slightly higher interest rates than first mortgages. This is because the lender’s position for repayment is secondary to the primary mortgage lender. In the event of default and foreclosure, the home equity lender can only collect after the primary mortgage lender recovers its money.

When it makes sense: If you have a specific need for a set amount of money, such as a major remodeling project or credit card debt, and you own a significant portion of your home outright.

When it doesn’t make sense: If you want to use the money for non-essential discretionary expenses or if your home is already serving as collateral for a large outstanding mortgage.

HELOC

A home equity line of credit is a second mortgage that works like a revolving credit line, similar to a credit card. The interest rate on a HELOC often fluctuates with the prime rate, although some lenders offer the option of a fixed-rate HELOC.

HELOCs typically have two stages of lending over a long period, usually 30 years. The first 10 years are the draw period, during which you only need to make interest-only payments. Afterward, the loan enters a repayment period of around 20 years, during which you must pay back both the principal and the interest.

When it makes sense: If you have a long-term financial need or are unsure about the exact amount you’ll need. A HELOC provides the flexibility to withdraw funds as needed.

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When it doesn’t make sense: If you are unable to handle a variable interest rate and fluctuating payments.

Cash-Out Refinance

A cash-out refinance allows you to refinance your existing mortgage for more than the outstanding balance, enabling you to receive the difference in cash. This option replaces your current mortgage, and depending on market conditions, you may be able to obtain a lower interest rate or better loan terms.

When it makes sense: If you were already considering refinancing your mortgage, such as when interest rates have fallen, and you prefer the simplicity of having a single large loan instead of multiple debts.

When it doesn’t make sense: If you don’t have a significant amount of equity in your home or if you won’t qualify for a lower interest rate than your current mortgage.

What is Home Equity?

Your home equity is the difference between the appraised value of your home and the amount you still owe on your mortgage. It represents the portion of your home that you own outright.

When you purchase a home, you automatically acquire equity equivalent to the down payment you made. As you make mortgage payments, reducing your debt, you increase your ownership stake or equity in your home. Major upgrades and improvements can also boost your home’s value, contributing to increased equity. Additionally, general appreciation in local property values can further increase the equity in your home over time.

How to Calculate Your Home Equity

To calculate your home equity, subtract your outstanding mortgage balance from the appraised value of your property. For example, if your home is appraised at $200,000 and you owe $120,000, your equity would be $80,000.

Lenders usually impose a maximum borrowing limit based on a percentage of your available equity, typically around 80% to 85%. Therefore, a new loan or refinance may be most beneficial if your home’s value has increased or if you’ve paid down a significant portion of your mortgage. Lenders also consider your loan-to-value ratio (LTV), which compares your outstanding mortgage balance to your home’s appraised value.

Calculating Loan-to-Value (LTV) Ratio

To calculate your LTV ratio, divide your mortgage balance by your home’s appraised value. In the above example, the mortgage balance of $120,000 divided by the appraised value of $200,000 would result in an LTV ratio of 60%.

An LTV ratio of 60% implies that you have 40% equity in your home. Given this ratio and assuming you meet other lender requirements, you would likely qualify for a refinance or home equity loan.

Benefits of Tapping Into Your Home Equity

One of the primary benefits of accessing your home equity is the ability to obtain cash at lower interest rates compared to personal loans or credit cards. When you need to cover significant expenses such as home renovations, college tuition, or debt consolidation, using your home equity can be a more cost-effective financing option.

“It’s often the cheapest form of financing available for homeowners,” says Vikram Gupta, Executive Vice President and Head of Home Equity at PNC Bank. “Because the loan is secured by the house, lenders can offer it at a lower rate compared to other consumer lending products.”

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Tapping into your home’s equity also offers greater flexibility. HELOCs and home equity loans usually offer multiple terms and repayment options. There are minimal restrictions on how you can use the funds, giving you the freedom to allocate them as needed.

Additionally, the interest you pay on a home equity loan or line of credit may be tax-deductible, provided you use the funds to “buy, build, or substantially improve” your home, according to the IRS. Remember to itemize deductions on your tax return to take advantage of this potential benefit.

Risks of Using Home Equity

While there are advantages to accessing your home’s equity, it’s important to be aware of the associated risks. The primary downside is that your home is used as collateral for the loan.

“If you are unable to make the monthly repayments for a sustained period of time, there is a risk that the lender could foreclose on (repossess) your house,” warns Vikram Gupta.

If you default on your loan and face foreclosure, you could lose your home and all the equity you’ve built. Furthermore, foreclosure can have severe repercussions, including a significant drop in your credit score, a seven-year mark on your credit report, restrictions on borrowing money for several years, and potential legal actions by the lender to collect additional money.

Another concern associated with using home equity is the potential for a downturn in property values. If home values decrease significantly, you could end up owing more on your mortgage than your home is worth. This situation, known as being “upside-down” or “underwater,” can limit your options and financial flexibility.

Choosing the Right Home Equity Option

The best home equity option depends on your specific financial needs and the amount you want to borrow. Consider the following scenarios:

  • Debt Consolidation: For refinancing high-interest debt, a home equity loan may be the best option. It allows you to borrow the exact amount needed to pay off outstanding balances, with fixed monthly payments and a fixed interest rate that makes budgeting easier. A HELOC may lead to increased monthly payments, potentially posing challenges for those on a fixed budget.
  • Higher-Education Expenses: If you need funds for college tuition, a HELOC might be more suitable. You can withdraw funds as needed over several years, accruing interest only on the amount borrowed.
  • Home Improvements: The choice depends on the project and your knowledge of the required funds. For a single-item project like an HVAC system or swimming pool, a home equity loan or cash-out refinance is recommended. If you’re embarking on a multi-phase remodel with ongoing costs and an indefinite timeline, a HELOC offers flexibility and reserves to accommodate the project’s budget fluctuations.

5 Ways to Increase Your Home Equity

If you’re interested in borrowing against your home equity but don’t yet meet the lender’s requirements, consider these methods to increase your home equity:

1. Put More Toward Your Mortgage

The most effective way to increase your home equity is by paying off your mortgage sooner. If paying off the entire remaining balance is not feasible, consider making larger monthly payments or adding extra payments throughout the year. Not only will this expedite the growth of your home equity, but it will also save you thousands of dollars in interest. Before making extra payments, check if your lender imposes early-payment penalties.

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2. Increase the Value of Your Home

Boosting your home’s value is another way to build equity. Consider adding rooms, expanding living spaces, enhancing landscaping, or making energy-efficient upgrades like solar panels. Be sure to research improvements that provide a high return on investment, such as kitchen renovations or upgraded roofs.

3. Refinance to a Shorter Loan

If you can afford higher monthly mortgage payments, consider refinancing to a shorter-term loan. Switching from a 30-year mortgage to a 15-year mortgage allows you to pay off your mortgage sooner and increase your home equity. Keep in mind that refinancing incurs closing costs, so weigh the benefits against the additional expenses.

4. Improve Your Credit Score

While building your credit score doesn’t directly increase your home equity, it expands your borrowing opportunities. Even if you have significant equity, a poor credit score can limit the amount you can borrow. Pay your bills on time and keep credit card balances low to improve your credit score.

5. Monitor Market Fluctuations

Real estate markets change over time, impacting home values and, consequently, your home equity. Stay informed about the value of your home by regularly checking listings sites like Zillow and Redfin. Knowing the market trends will help you make informed decisions about when to tap into your home equity.

Other Considerations when Taking Out a Home Equity Loan

A few additional factors to keep in mind when considering a home equity loan:

  • Home equity rates are relatively low compared to credit cards and other types of loans. They may also be easier to qualify for since they are secured loans backed by your home.
  • Home values can fluctuate. Be cautious with large home equity loans if home values drop, as you could end up owing more than your home is worth.
  • Remember that your home is on the line. If you already have a low-rate mortgage, carefully consider whether a cash-out refinance is the right choice. Falling behind on payments puts your home at risk of foreclosure.

Next Steps

If you’re considering borrowing against your home equity, follow these steps:

  1. Estimate your home’s value to determine your eligibility for home equity loans or refinancing. Divide your outstanding mortgage balance by your home’s value to gauge your loan-to-value ratio.
  2. Develop a plan that addresses your financial needs and outlines how and when you’ll repay the loan. Only tap into your home equity for purposes that provide a positive financial return.
  3. Start the process by shopping around and comparing offers from multiple lenders. Bankrate’s reviews of home equity lenders can provide valuable insights during your search.

FAQ about Taking Out Home Equity

  • Is it a good idea to take equity out of your home?
  • Which is better: Cash-out refinance or home equity loan?
  • How much equity can I take out of my home?
  • Can I use a home equity loan for anything?

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