Homeowners in the U.S. had $5.7 trillion in equity borrowing potential at the end of 2018, according to Black Knight, a mortgage-data and technology company. So there are opportunities for many homeowners to get a home equity loan, home equity line of credit or a cash-out refinance. But should you? And if so, how much equity should you cash out of your home?
The good news is that rates on these loans have stayed put or even declined since the Federal Reserve said it doesn’t expect to raise the cost of borrowing in 2019 and has so far stuck to that plan. Tax consequences also must be considered before taking out an equity loan. Federal tax law eliminates the interest deduction for equity loans unless the money is spent on improvements that will raise property value.
If, after weighing all the facts, you determine that a home equity loan, line of credit or cash-out refinance is right for you, there are a few things to know.
Banks restrict how much equity you can take
Homeowners used to be able to borrow 100 percent of their equity, says Jay Voorhees, broker and owner of JVM Lending, a mortgage company in Walnut Creek, California. Today, most lenders limit equity borrowing to 80 percent of your cumulative LTV, or loan-to-value equity.
LTV is calculated like this: If your home is valued at $300,000 and you owe $200,000, then you have $100,000 of equity. At 80 percent cumulative loan-to-value, the total amount of outstanding borrowing would be limited to $240,000 ($300,000 x 0.80 = $240,000). You must retain 20 percent equity in the home, which is $60,000 ($300,000 x 0.60 = $60,000). Subtract the amount you have to retain from your total equity, and you’d be able to borrow $40,000 ($100,000 − $60,000 = $40,000).
Your credit score still plays a role regarding the rate you can get. Your home is the primary equity you are using, but if you have a poor payment history or a large debt load, taking on more debt can put you at risk of foreclosure. Lenders may compensate for this by lowering the amount of equity they offer you or by increasing the interest rate on the loan.
Know how much you need to borrow
The amount of money you need to borrow will often depend on what you are doing with it. Some people use equity loans as a way to consolidate unsecured, high-interest debt and drop overall payments. Others will use it for a remodel or home improvement project. These kinds of goals come with set budgets that make it easy to anticipate the amount you want to borrow. If you are simply looking for a low-interest equity option to deal with unforeseen emergencies, then it can be trickier to know what to ask for.
The amount you borrow for debt consolidation should be kept low. If bad spending habits got you to the place where you need to consolidate, don’t tempt yourself with extra equity and be sure your habits are truly reformed before doing this, or your cards will end up filling up quickly once again.
In cases of home improvement projects, give yourself a 10 to 20 percent overrun budget to deal with unforeseen costs in addition to your remodel estimate. For those looking to have emergency funds, choose a rate based on something large that you couldn’t afford to pay with savings, like a roof replacement, and ask for enough to cover it if needed.
The type of loan you ask for may also change based on whether this money will be spent quickly or not.
In cases where you won’t be borrowing immediately, Voorhees suggests borrowers “go to the limit” with a home equity line of credit (HELOC) because they don’t have to withdraw the whole line of credit. Some borrowers can have access to a big chunk of money and withdraw only what they need; for others, the temptation to spend it all is too much.
A conservative approach is recommended for a home equity loan, which is for a fixed amount rather than an open credit line. Consumers who want to tap their home’s equity for home improvement projects should decide how much they need and pad it a little for cost overruns, says Kelly Kockos, senior vice president of home equity for Wells Fargo in San Francisco.
If you’re looking to tap the value in your home, learn more about the requirements to borrow from your home equity.
Know how each type of loan works
Home equity loans, HELOCs and cash-out refinances aren’t risk-free. Borrowers should try to pay off a HELOC, in particular, within a reasonable time frame, though they may elect to keep the line open for future use.
Home equity loan
This is a second mortgage for a fixed amount, at a fixed interest rate, to be repaid over a set period. It works in a similar manner to a mortgage and is typically at a slightly higher rate than a first mortgage. This is because if you foreclose, they are behind the first lender in line for repayment through the sale of the home.
Home equity line of credit (HELOC)
HELOCs are a second mortgage with a revolving balance, like a credit card, with an interest rate that varies with the prime rate. HELOCs often come with two lending stages over a long period, such as 30 years. During the first 10 years, the line of credit is open and all debt payments are interest-only. The loan then converts to a 20-year repayment plan that includes principal.
These loans are a mortgage refinance for more than the amount owed. The borrower takes the difference in cash. It is also called a cash-out refi. These are commonly used as a tool in remodels. Buyers can take a short-term construction loan and then use the cash-out on their home’s new, higher value to repay the construction costs.
Home equity rates are still low
Home equity loans and HELOCs carry much lower rates than credit cards.
“Home equity loans are advantageous because the rates are usually lower, and they’re easier to qualify for since the banks are using your house as collateral,” says Samuel Rad, a certified financial planner at Affluencer Financial in Los Angeles and college lecturer.
For example, Bankrate’s weekly rates survey of May 15 shows that the average interest rate on variable-rate credit cards is 17.8 percent. Compare that with 5.91 percent on home equity loans and 6.73 percent on HELOCs.
This makes home equity loans or HELOCs a good option for consolidating high-interest debt.
With a cash-out refinance loan, you replace your mortgage with a new mortgage for more than what you owe and take the difference in cash. This means higher monthly payments. People who are in the second half of their mortgage amortization should beware, Rad says, as they will have to start paying interest all over again with a cash-out refi.
“In a 30-year fixed-rate mortgage, people are paying interest for the first 15 years,” Rad says. “After that, they begin paying down their principal. The drawback of a cash-out refi is that the process resets, and they have to start paying interest again.”
Remember: Home values can crash
One reason to be careful with home equity loans is that home values fluctuate. If you take out a big loan and the value of your home drops, you could end up owing more than what your house is worth. This is a condition known as being “upside down” or “underwater.” The housing crash of 2008 left millions of borrowers stuck in homes they could not sell because their values sank.
“We had a financial crisis … which showed us home values can drop suddenly. This is something borrowers should think about before taking out equity from their home,” says Ben Dunbar, an investment adviser for Gerber Kawasaki Investment and Wealth Management in Santa Monica, California.
Your house is on the line
If you bought your house or refinanced when rates were super-low, you have to ask yourself how wise it is to borrow against your home at a rate that’s considerably higher than your first mortgage. A cash-out refi might be a better option if you can get a good rate, but you’d be starting all over again with interest payments.
Before taking out a home equity loan, remember that if you default for any reason, you can end up losing your home.
“The risks of getting home equity loans are big because your house is the collateral,” Dunbar says. He recommends you know exactly how much you need and try to repay it as soon as possible.
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