Your home is one of your greatest assets and leveraging the equity you’ve built doesn’t have to be difficult. You can convert funds into cash needed to achieve an important life goal or cover a major expense. Home equity loans, home equity lines of credit (HELOCs), and cash-out refinances are the most common ways to tap into the equity in your home. But before you apply, it’s worth understanding how home equity works to know which of these three is best suited.
Simply put, home equity is a term used to describe the amount of property you own outright. For example, if you make a 10% down payment when you buy a house, you immediately have 10% of the equity in the home, because you only have to take out a mortgage for the remaining 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 the outstanding balance of your mortgage from the market value of your home. If you have other loans secured against your home, be sure to include those balances in the equation.
For example, let’s say your house is currently worth $425,000 and you still owe $249,000 on your original mortgage. He also has a second mortgage of $43,000 on the home. 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 dive into the three ways you can build equity in your home.
A home equity loan is a popular option that allows you to convert 75% to 85% of your home’s equity into cash. It is a second mortgage, which means that your home serves as collateral for the loan. This also means you will have two monthly mortgage payments, one for your original home loan and one for your home equity loan.
If your application is approved, the home equity loan lender disburses the loan proceeds in a lump sum. The amount you receive is paid over time in equal monthly installments, making the balance more manageable as 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 results in predictable monthly payments
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Predictable monthly loan payments make long-term budgeting easier
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Loan terms of up to 30 years.
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Closing costs are approximately 2% to 5% of your loan amount.
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Risk of foreclosure if you default on your loan payments
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Market Downturns Could Leave You Owing More on Your House Than It’s Worth
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Pay interest on the entire loan amount, regardless of whether 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, as with a HELOC (more on this below).
They’re also good 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 get to keep the terms of your first mortgage.
A home equity line of credit also acts as a second mortgage and typically gives you access to up to 85% of the equity you have in your home. However, instead of receiving the funds in a lump sum, you are given a revolving line of credit that works similarly to a credit card.
You can withdraw funds as often as you need, up to your credit limit, during what is called the “withdrawal period.” On a 30-year HELOC, the withdrawal period typically lasts 10 years. As you pay back what you borrow, the line is replenished and remains available for use until the end of the withdrawal period.
The remaining balance is then paid 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 payment terms compared to home equity loans
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You only pay interest on what you borrow
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Some lenders allow interest-only payments during the withdrawal period.
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HELOCs typically charge variable interest rates, so your payments will fluctuate
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Closing costs range from 2% to 5% of the amount borrowed.
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You risk foreclosure if you can’t keep up with payments
HELOCs are ideal if you need to cover several large expenses over time. For example, maybe you are renovating your house in stages and aren’t sure how much money you will need over time.
HELOCs are also good if you want to keep the super-low rate on your first mortgage, because you don’t have to replace your original mortgage like you would if you refinanced.
A cash-out refinance is another way to tap into the equity in your home. However, it requires you to replace your current mortgage with a new, larger one that has different terms.
Most cash-out refinance lenders limit your borrowing power to 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 up to $81,000 (($345,000 x 0.80) – $195,000) in cash.
With a cash-out refinance, the lender pays off your existing mortgage and disburses the amount you cash out shortly after the loan closes. You would then begin paying off the new $276,000 mortgage, which is equal to the amount you already owed, plus the principal you converted into 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 as opposed to home equity loans and lines of credit, which add a second monthly payment
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Up to 100% of home equity can be accessed 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 are unable to make your monthly mortgage payments.
A cash-out refinance may be worth it if you can get better terms on your new mortgage than your original. For example, maybe you bought in the last few years and have an interest rate higher than 7%. You could replace that mortgage with one that charges a lower rate.
There are three main ways to access the equity in your home. You can get a home equity loan, a home equity line of credit, or a cash-out refinance. The best option for your financial situation depends on the amount of equity you have built up, your financial profile, and whether you want to refinance your current home loan or take out a second mortgage. Shared equity agreements and reverse mortgages are also options, but they are less common among homeowners.
Several circumstances may 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 home equity to create an emergency cushion or cover unexpected costs.
Some mortgage lenders allow you to withdraw equity from your home immediately or shortly after closing your original mortgage, assuming you have enough equity. However, you will pay closing costs with home equity products, so hiring one right away can put you in a difficult financial situation. You could find yourself underwater on your home loan if market conditions change.
The amount of equity you can withdraw from your home depends on the lender, your financial profile, and the type of mortgage you choose to access the equity in your home. That said, you can typically borrow up to 80% of your home’s equity.
Laura Grace Tarpley Edited this article.