Your home is one of your biggest assets, and it doesn’t have to be difficult to leverage the equity you’ve built up. You can convert the funds into cash needed to achieve a major life goal or cover a major expense. Home equity loans, home equity lines of credit (HELOC), and cash-out refinances are the most common ways to tap into the equity in your home. But before you apply, it helps to understand how your home equity works so you know which of these three is best for you.
In a nutshell, home equity is a term used to describe how much of your home you own. For example, if you put 10% down when purchasing a home, you immediately have 10% equity in your home because you only need to take out a mortgage for the other 90%.
Your home equity generally increases as you make monthly mortgage payments or as the value of your home increases.
Calculate your home equity by deducting your mortgage balance from the market value of your home. If you have other loans secured by your home, be sure to factor those balances into the equation.
For example, let’s say your home is currently worth $425,000 and you still owe $249,000 on your original mortgage. You also have a second mortgage of $43,000 on the house. In this case, the equity in your home would be:
$425,000 – $225,000 – $43,000 = $157,000
You have $157,000 in home equity, which means you own almost 37% of your home. Assuming you meet the lending guidelines, you will be able to borrow a percentage of this amount.
Now let’s look at three ways you can leverage your home equity.
A home equity loan is a popular option that allows you to convert between 75% and 85% of the equity in your home into cash. This is a second mortgage, meaning your home serves as collateral for the loan. This also means that you will have two monthly mortgage payments, one for your initial mortgage and one for your home equity loan.
If your application is approved, the home equity lender disburses the loan proceeds in a lump sum. The amount you receive is payable over time in equal monthly installments, making the balance more manageable because you’ll know what to expect. Terms typically last up to 30 years.
Here’s an example: Let’s say your house is worth $325,000 and you owe $175,000 on your current mortgage.
You could potentially access between $68,750 [($325,000 x 0.75) – $175,000] And $101,250 [($325,000 x 0.85) – $175,000] with a home equity loan.
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Fixed interest rate allows for predictable monthly payments
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Predictable monthly loan payments make long-term budgeting easier
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Loan duration up to 30 years
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Closing costs are approximately 2-5% of your loan amount
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Risk of seizure if you default on your loan
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Market downturns could cause you to owe more than your home is worth.
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You pay interest on the entire loan amount whether or not you use the money
Home equity loans are ideal for homeowners who need money for a large one-time expense. This is because you will receive the money in a lump sum rather than in stages, like with a HELOC (more on this below).
They’re also useful if you have a low interest rate on your original mortgage and don’t want to give it up by refinancing. When you take out a second mortgage, you keep the terms of your first mortgage.
A home equity line of credit also acts as a second mortgage, typically giving you access to up to 85% of the equity in your home. However, instead of receiving the funds in a lump sum, you get a revolving line of credit that works similarly to a credit card.
You can withdraw funds as often as necessary, up to the credit limit, during what is known as the “withdrawal period”. On a 30-year HELOC, the draw period generally lasts 10 years. As you repay what you borrow, the line is replenished and remains available until the end of the drawing period.
The remaining balance is then payable over a period of 10 to 20 years, depending on the HELOC lender. It is common to make interest-only payments during the withdrawal period and then interest and principal payments during the repayment period.
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Flexible withdrawal and repayment terms compared to home equity loans
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Pay interest only on what you borrow
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Interest-only payments are permitted by some lenders during the draw period.
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HELOCs often charge variable interest rates, so your payments will fluctuate
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Closing costs are between 2% and 5% of the amount borrowed
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You risk foreclosure if you can’t keep up with your payments
HELOCs are ideal if you need to cover several large expenses over time. For example, you may be renovating your home in stages and you’re not sure how much money you’ll need over time.
HELOCs are also useful if you want to keep your rate very low on your first mortgage because you don’t need to replace your original mortgage like you would if you were refinancing.
A cash-out refinance is another way to tap into the equity in your home. However, this requires you to replace your current mortgage with a new, larger loan with different terms.
Most refinance lenders cap your borrowing power at 80% of the home’s value. So if your home has a fair market value of $345,000 and you owe $195,000, you could potentially access $81,000 [($345,000 x 0.80) – $195,000] in cash.
With a cash-out refi, the lender pays off your existing mortgage and disburses the amount you withdraw shortly after the loan closes. You will then start paying the new mortgage of $276,000, which is the amount you already owe, plus the equity you converted to cash ($195,000 + $81,000 = $276,000).
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Potentially Get a Lower Mortgage Rate on Your New Mortgage
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One monthly mortgage payment, unlike home equity loans and lines of credit, which add a second monthly payment.
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Up to 100% of home equity is accessible through VA loan cash-out refinances
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If you already have a low mortgage rate, you would lose it by replacing your home loan with a new one.
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Closing costs between 2% and 6% of the new loan amount
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Higher monthly payments could become a financial burden
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You risk losing your home to foreclosure if you fail to make your monthly mortgage payments.
A cash-out refinancing can be attractive if you can get better terms on your new mortgage than on your original loan. For example, you may have purchased within the last two years and have an interest rate above 7%. You can replace this mortgage with one that charges a lower rate.
There are three main ways to access your home equity. You can take out a home equity loan, home equity line of credit, or cash out refinancing. The best option for your financial situation depends on the amount of equity you have built, your financial profile, and whether you want to refinance your current home loan or take out a second mortgage. Equity sharing agreements and reverse mortgages are also options, but they are less common among homeowners.
Several circumstances can make borrowing against your home equity an ideal option. Common uses include debt consolidation for those struggling with high-interest credit card debt or to cover the cost of home repairs or improvements. Others tap into their home equity to build an emergency cushion or cover unexpected costs.
Some mortgage lenders allow you to take out the equity in your home immediately or shortly after closing on your original mortgage, provided you have enough equity. However, you’ll pay closing costs with home equity products, so taking out one right away can put you in a difficult financial situation. You could find yourself underwater with your home loan if market conditions change.
The amount of equity you can take out of your home depends on the lender, your financial profile, and the type of mortgage you choose to access your home equity. That said, you can typically borrow up to 80% of the equity in your home.
Laura Grace Tarpley edited this article.
