If you have equity in your home and a decent credit profile, don’t be surprised if you’re getting offers from mortgage lenders.
Homeowners in the U.S. have $5.4 trillion in equity borrowing potential, the highest amount on record, according to Black Knight, a mortgage-data and technology company.
So there are opportunities to get a home equity loan, home equity line of credit or a cash-out refinance. But should you? And if so, how much?
The answers are more complicated for homeowners today for a couple of reasons. First, rates on mortgages, including equity loans, are going up, and the Federal Reserve is expected to raise the cost of borrowing two or three more times this year.
Tax consequences also must be considered before taking out an equity loan. The new 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 loan-to-value.
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). So, 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).
Know how much you need to borrow
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 hunk 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 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, though they may elect to keep the line open for future use.
Home equity loan
A second mortgage for a fixed amount, at a fixed interest rate, to be repaid over a set period.
Home equity line of credit (HELOC)
A second mortgage with a revolving balance, like a credit card, with an interest rate that varies with the prime rate. Pronounced HE-lock.
A mortgage refinance for more than the amount owed. The borrower takes the difference in cash. Also called a cash-out refi.
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 CFP professional at Affluencer Financial in Los Angeles and college lecturer.
For example, Bankrate’s weekly rates survey of May 30 shows that the average interest rate on variable-rate credit cards is 17 percent. Compare that with 5.56 percent on home equity loans and 5.83 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 — 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.