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*NOTE: This article was originally written by Laura Gariepy of Point.com on November 6, 2024. (Link to Original Article)
Your home equity can help cover major financial goals and expenses. Learn how to take equity out of your home, including pros, cons, and different methods.
You’ve heard that your house can be a powerful financial resource, but you may wonder how to take equity out of your home. Fortunately, you have several methods of tapping your home equity at your disposal.
We’ll cover five options and offer suggestions to increase your equity. That way, you can make an informed decision that helps you achieve your goals.
Understanding equity
Home equity is the appraised value of your home, minus what you still owe on your mortgage. For instance, if your property is worth $500,000, and your mortgage balance is $150,000, you have $350,000 in home equity.
You can draw on your equity (sometimes known as borrowing against it) to achieve numerous goals. Some homeowners borrow against their home’s value to repair or renovate the residence. Others use the money to pay off high-interest debt, such as credit cards. You can generally use your home equity for any purpose (though your lender may stipulate exceptions).
How to get equity out of your home
There are several ways you can get equity out of your home:
Cash-out refinance
A cash-out refinance is the process of taking out a brand new mortgage that’s large enough to pay off your original home loan and put a lump sum of cash back in your pocket. Your new mortgage may have a different rate and term than your previous home loan.
The biggest advantage to this approach is that you’ll still only have one housing-related debt to manage. However, interest rates have increased significantly in the past year. So, if you purchased or refinanced your home when rates were lower, your new mortgage could come with higher finance charges, and consequently, a higher monthly payment.
Note: Rates may eventually drop significantly, making the cash-out refinance a more attractive option. Or, if you go this route now, you could refinance again later to save money.
Home equity loan
A home equity loan, often called a second mortgage, runs alongside your primary home loan and functions similarly to a personal loan. You get a lump sum of cash upfront and then have a set repayment term (generally between five and 30 years).
Typically, a home equity loan has a fixed interest rate, giving you predictable monthly payments for the life of the debt. Plus, since your property secures the loan (as is the case with all the products we discuss here), you may enjoy a lower interest rate than with an unsecured loan.
Home equity line of credit (HELOC)
A home equity line of credit (HELOC) also runs concurrently with your primary mortgage, but it functions more like a credit card than a personal loan. You receive a line of credit and can spend up to the limit during the draw phase, which often lasts for ten years. Generally, you’re permitted to make interest-only payments while in the draw phase. However, if you want to re-borrow from your line, you can pay down (or off) the principal balance.
Once the draw phase ends, you enter the 20-year repayment phase, where you’re responsible for making principal and interest payments until the debt is fully repaid. Your HELOC may have a variable interest rate, leading to less predictable monthly payments than a home equity loan.
A HELOC could be a viable solution if you want access to ongoing funding or are unsure how much money you need. However, a home equity loan may be a better fit if you have a firm budget for the funds.
Reverse mortgage
If you're 62 or older, a reverse mortgage could be an ideal way to tap your home equity and supplement your retirement income. With a reverse mortgage, a lender pays you a percentage of your equity as a lump sum, in monthly installments, or as a line of credit, depending on your arrangement. You can continue to live in your home until you die.
However, reverse mortgages accrue interest and fees each month. When you no longer live on the property, you or your heirs must either pay off the balance due to keep the home or sell the property to satisfy the lender.
On the plus side, unlike the previous options on this list, you won’t need to meet a specific credit score requirement to qualify. Income requirements for a reverse mortgage are also much more lenient than the options we’ve discussed above. That means a reverse mortgage could be a smart idea if your credit is mediocre to poor or you’re otherwise struggling financially.
Home Equity Investment (HEI)
A Home Equity Investment (HEI) is an agreement where you receive a portion of your home’s equity upfront in exchange for a percentage of the property’s future appreciation. Unlike a home equity loan or HELOC, you won’t have to make monthly payments. Instead, you can repay your investment partner at any point during the HEI term (30 years).
Typically, HEIs have more lenient financial eligibility criteria, making them easier to qualify for than more traditional home equity-based products. However, the investment process still involves a property appraisal, so it may take a while for you to receive your funds.
You can qualify for an HEI with a credit score above 500, and there are no income requirements.
Requirements for home equity products
Each lender will have different eligibility criteria for its home equity products. However, here are some standard requirements you’ll likely encounter:
Loan-to-value (LTV) ratio
Your loan-to-value (LTV) ratio expresses how much you owe on your mortgage in relation to your home’s value. The lower your LTV ratio, the better because it signifies your property is worth more than your current debt balance.
Generally, lenders like to see an LTV of 85% or less to underwrite a home equity-based product. You can calculate your loan-to-value ratio by dividing your current mortgage balance by your current appraised value.
Let’s look back at our previous example, where you have a home worth $500,000 and a $150,000 mortgage balance. Your LTV is 0.30 or 30% (150,000/500,000). In this case, you’d easily meet this qualification.
Debt-to-income (DTI) ratio
Your DTI ratio shows lenders how much of your income goes towards servicing debt. Lenders typically like to see DTI ratios well under 50%, but the lower your DTI, the better.
A low DTI shows you have sufficient income to meet your financial obligations, including the new loan or line of credit you want. You can calculate your DTI by dividing your monthly debt payments by your monthly income.
For example, if you pay $2,500 monthly to cover your credit cards, mortgage, and student loan and earn $7,500 monthly, your DTI is 0.33 or 33%. In this case, your DTI is likely low enough to satisfy most lenders.
Note: Some home equity-based products, like the HEI, don’t have a DTI requirement.
Credit score
Your credit score shows lenders how responsibly you manage debt. It’s a three-digit metric, typically ranging from 300-850, where higher scores are better.
Generally, lenders require your credit score to be in the mid-600s or higher. There are several ways you can learn your credit score. You may be able to spot it on a credit card statement. You can also request it from a credit score service or a non-profit credit counseling agency.
If your credit score is low, you can take steps to improve it. Start by paying down your current debt. As you do that, be sure to pay all of your creditors on time, every time. Eventually, you should see your score climb.
Remember: If your credit score is low, you may still be able to qualify for a reverse mortgage or HEI.
Verifiable income
Your lender will need to confirm your ability to repay your new debt. You may have to provide paystubs, W2s, tax returns, or other documents upon request.
The pros and cons of using home equity
The benefits of drawing on your equity
There are several benefits of drawing on your equity:
Access to liquid funds
You may consider your home to be an asset. However, the property itself is illiquid, meaning you can’t easily exchange your home for a good or service you need.
When you draw on your equity, you convert part of your home’s value into cash. Then, you can use the liquid funds to cover almost any expense quickly and easily.
Financing opportunities
When you borrow against your home equity, you may receive a significant sum of cash. Those funds can finance a large expense, such as putting an addition on your house or taking the vacation of a lifetime.
Wealth building
You can also use your home equity to improve your overall financial situation. For example, you could pay off high-interest debt or invest the money where it might grow at a faster rate than the interest you’re paying on the home equity-based product (if applicable).
In addition, you can use the funds to diversify your investment portfolio. For example, you could purchase a rental property, buy precious metals, or invest in a business.
Competitive rates
There are many ways to finance your dreams without tapping into your equity, such as personal loans or credit cards. However, because those borrowing options tend to be unsecured (no collateral required), they often have a higher interest rate than a home equity-based product, which is secured by your property.
The disadvantages of drawing on your equity
While there’s an upside to drawing on your equity, there are some pitfalls, too:
Increased debt
In most cases, tapping into your home’s equity results in debt, adding a new expense to your budget. You should have a realistic plan to repay your lender that doesn’t stretch you too thin financially. Plus, the new obligation can push your debt-to-income (DTI) ratio to an all-time high, potentially making it difficult to qualify for additional credit.
Risk of default
Home equity financial products use your house as collateral to secure the debt. If you default on that debt, the lender can foreclose on your property.
Cost of borrowing
Like your original mortgage, home equity products often have closing costs. Closing costs typically range between 2%-5% of the transaction, so you could pay thousands to tap into your equity.
Housing market shifts
The value of your home will continue to shift over time. Generally, the price will increase, but that isn’t guaranteed.
If your home drops in value too much, you could owe more than what it’s worth, known as being underwater. Having negative equity can make it very hard to sell the property because a lender won’t issue a loan large enough to a potential buyer to bring you back to even, let alone generate a profit.
4 ways to increase the equity in your home
If you don’t have enough home equity to pay for your dreams today, don’t worry. You can increase it by:
Increasing your monthly payment
If you can spare the money, pay more on your mortgage monthly, allocating the overage to the principal balance. Each time you do this, you’ll gradually reduce your mortgage and increase your equity.
Making extra mortgage payments
Submit half of your mortgage payment to your lender every two weeks. Doing so results in 13 months worth of payments annually, which grows your equity and can eventually shave years off your repayment term.
Pro Tip: Windfalls like tax refunds or inheritances can drop your mortgage balance quickly, giving your equity a sharp, quick boost.
Increasing your home’s value
You can substantially augment your home equity by increasing your property’s value. Smart home renovations and upgrades can instantly make your home worth more. You can get the best bang for your buck by tackling projects like adding a deck, upgrading your kitchen (including matching, energy-efficient appliances), and renovating your bathrooms.
Applying for an equity product during a market high
If you apply for a home equity-based product while your property value is at an all-time high, you may be able to get more funding. However, you should go into the transaction with a clear budget for the funds and be aware of the risks, such as potentially becoming underwater on your mortgage.