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Your home equity works a lot like a piggy bank. It’s a great place to go when you need money to pay for major expenses like home improvements, medical costs, or college tuition. Home equity is how much of your home you own – it’s your home’s market value minus what you owe your lender on your mortgage loan.
If you’ve owned your home for a few years and need cash, now could be an excellent time to tap in and withdraw some equity. Between 2021 and 2022, the average U.S. homeowner gained $60,000 in home equity.
You can pull equity out of your home in three ways: You get an entirely new loan with a cash-out refinance. And if you’re not interested in refinancing, you can take out a home equity loan or a home equity line of credit (HELOC).
Getting equity out of your home may not be as simple (or gratifying) as taking a hammer to a piggy bank. But we can help you avoid common pitfalls by sharing what you need to know and do to release the equity in your home.
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Understanding How Home Equity Works
Subtract the amount you owe on your mortgage(s) from your property’s market value to calculate your home equity.
For the visual learners among us, if your home is worth $500,000 and you owe $300,000 on your mortgage, your home equity is $200,000 ($500,000 – $300,000 = $200,000). To calculate your home equity as a percentage, divide your equity by the value of your home. In our example, that’s $200,000 / 500,000 = 0.4, or 40%.
The main thing to understand about home equity is that the amount you have will depend on your loan-to-value (LTV) ratio. LTV ratio is the amount of money you owe against the appraised value of your property. Your LTV ratio is the inverse of your equity. If we stay with our previous example, your LTV ratio is 60% because your home equity is 40%.
Home Equity Loan
A home equity loan is a type of second mortgage that lets homeowners borrow a lump sum of money by tapping into their home’s equity. But you won’t be able to borrow more than 85% of your home’s value minus what you owe on your mortgage.
To qualify for a home equity loan:
- Your credit score should be in the mid-600s or higher.
- Your debt-to-income (DTI) ratio should be 43% or less.
- There should be at least 15% – 20% equity.
Let’s return to our example of the $500,000 home with the $300,000 mortgage. You can borrow up to 85% of your home’s value ($500,000), which is $425,000. But you owe $300,000 on your mortgage. To calculate how much you can borrow, you subtract $300,000 from your $425,000 to figure out your borrowing limit, which is $125,000 ($425,000 – $300,000 = $125,000).
Home equity loans typically have lower interest rates than credit cards or personal loans, but their rates are typically slightly higher than primary mortgage interest rates.
Because home equity loans require underwriting and processing, it can take around 2 – 6 weeks to be approved and get your money.
Let’s break down the pros and cons of home equity loans.
Home equity loans have long repayment periods, which can keep your monthly payments low and affordable. Most home equity loans are repaid over 10 – 20 years.
Home equity loans have fixed interest rates. You’ll know exactly how much to pay each month because your monthly home equity loan payment will never change, even if market interest rates go up.
You can deduct mortgage interest from your home equity loan if you use it to “buy, build or substantially improve” your home.
The closing costs for home equity loans are usually lower than closing costs for a refinance.
You’ll pay your first mortgage and your second mortgage at the same time, which may become a financial burden.
Home equity loans typically have slightly higher interest rates than HELOCs and cash-out refis.
A home equity loan provides a lump-sum, one-and-done payout, which may not be the right solution for your situation.
Home Equity Line of Credit
A home equity line of credit (HELOC) is like a credit card that uses your property as collateral. You borrow money whenever you need it up to your borrowing limit (usual limits fall between 85% – 90% of your home’s value).
Home equity loans and cash-out refinances supply lump-sum payments to borrowers. A HELOC is a line of credit that offers the flexibility of periodic withdrawals during the draw period. With a HELOC, you pay back interest on the money you withdrew during the draw period, not the dollar amount you borrowed. At the end of the draw period (which usually lasts around ten years), the repayment period begins, and you pay back interest and principal.
Another critical difference between HELOCs and home equity loans is that a HELOC’s interest rate is variable, which means its rate will adjust with market rates.
The eligibility requirements for a HELOC are similar to home equity loan requirements. Lenders prefer a credit score in the mid-600s and a 43% DTI ratio.
Accessing your home’s equity with a HELOC will take some time, usually 2 – 6 weeks, from applying to underwriting.
Keep reading to learn more about the pros and cons of HELOCs.
HELOCs offer the most flexibility, allowing you to borrow the money you need on your schedule. Like a credit card, you borrow money when needed and in different amounts each time.
With a HELOC, you only pay interest on the amount you borrow. If your HELOC’s borrowing limit is $200,000 and you withdraw $50,000 during the draw period, you’ll only pay interest on the $50,000.
The closing costs for HELOCs are usually lower than closing costs for a refinance.
HELOCs charge variable interest rates. If interest rates go up, your monthly payments probably will, too.
When the repayment period kicks in, you’ll start paying your HELOC and primary mortgage simultaneously, which may become a financial burden.
If the value of your property goes down, your mortgage lender may reevaluate your HELOC and freeze the line of credit or cancel it.
If you sell your home, your lender may require you to pay off your HELOC at closing.
A cash-out refinance trades your existing mortgage with a larger mortgage and lets you pocket the difference as a lump sum of cash. The new loan can also have a different set of loan terms.
The main difference between a cash-out refi and a home equity loan and HELOC is a cash-out refi replaces your existing primary mortgage. And a cash-out refi’s repayment term – typically 30 years – is longer than the term for most home equity loans or HELOCs.
This form of refinancing replaces your original mortgage with a brand new loan encompassing the remaining balance of the previous mortgage and the new cash out.
You need at least 30% equity in your home to qualify for a cash-out refi and a credit score of 620 or greater. The qualifying DTI ratio requirement will vary by lender, but lenders generally prefer a DTI ratio of 36% – 50%.
Cash-out refi takes around 45 – 60 days to close.
We’ve outlined the pros and cons of cash-out refinancing to help you decide if it’s right for you.
A cash-out refinance replaces your original primary mortgage. Unlike home equity loans and HELOCs, a cash-out refi stays in the first mortgage position. First mortgages generally have lower interest rates than second mortgages, so you’ll probably get a better interest rate with cash-out refi than a HELOC or home equity loan.
If interest rates have gone down since you first got your mortgage, you could end up with a lower interest rate, and a lower monthly mortgage payment with a cash-out refinance.
Once you close your cash-out refi and pay off your existing mortgage balance with your brand-new, larger mortgage, you’ll get the difference in a lump sum.
A cash-out refi is far from fast. It can often take 45 – 60 days to close, including the number of days it takes before you receive your cash payout.
A cash-out refi is a new loan with a new set of closing costs. The closing costs for a cash-out refi are typically higher than for home equity loans or HELOCs.
If your refinanced loan doesn’t have a lower interest rate than your original mortgage, you might have a higher monthly mortgage payment.
How To Increase Your Home’s Equity
Some factors that build home equity will be out of your control (think: home prices and the state of the economy), but there are strategies you can implement to build equity on your terms.
You can build equity in your home by:
- Increasing the value of your home: Certain upgrades like adding livable square footage or remodeling kitchens and bathrooms can increase the value of a home.
- Paying down your mortgage quicker: If you can afford it (and can afford or manage prepayment penalties), you can build equity by paying down your mortgage faster, which comes with the added benefit of saving money on interest.
- Refinancing to a shorter-term loan: Refinancing to a shorter-term loan can help you pay off your loan earlier and build equity faster. This strategy isn’t for everyone, though. The shorter the loan, the higher your monthly mortgage payments will be.
- Taking advantage of real estate market fluctuations: If your home goes up in value, your equity will increase. If you have a good understanding of the real estate market and can time it right, try buying a lower-priced home that will yield greater value than a higher-priced home when the market goes up.
Alternatives to Home Equity Financing
Home equity financing isn’t the only game in town. Consider some common alternatives, including:
Credit cards: Credit cards are one of the easiest, fastest, and most convenient ways to borrow money, but their interest rates are pretty steep.
Personal loans: Personal loans are secured or unsecured loans that provide lump-sum payments. An unsecured loan (think: not backed by collateral) will have a higher interest rate, but your assets (like your home, car, or other valuables) won’t be at risk.
Home improvement loans: Home improvement loans have stricter credit requirements than personal loans or credit cards, and they are only good for one thing: home improvements. But it’s a great way to borrow money at a lower interest rate to make home renovations.
Which Is the Best Option?
Tapping into your home equity can be a financially savvy solution – but it won’t work for every scenario.
If you need a small amount of money and the situation isn’t urgent, the time, effort, and money you’ll spend trying to get a home equity loan may not be worth your while. But if you must break into your home equity in case of emergency, make sure the emergency – or large expense – is big enough to be worthwhile.
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The Short Version
- Subtract the amount you owe on your mortgage(s) from your property’s market value to calculate your home equity
- A home equity loan is a type of second mortgage that lets homeowners borrow a lump sum of money by tapping into their home’s equity
- HELOCs offer the most flexibility, allowing you to borrow the money you need on your schedule
CoreLogic. “Homeowner Equity Insights.” Retrieved September 2022 from https://www.corelogic.com/intelligence/homeowner-equity-insights/#
Internal Revenue Service. “Interest on Home Equity Loans Often Still Deductible Under New Law.” Retrieved September 2022 from https://www.irs.gov/newsroom/interest-on-home-equity-loans-often-still-deductible-under-new-law