Homeowners in the U.S. had $6.2 trillion in equity borrowing potential as of the end of 2019, according to Black Knight, a mortgage data and technology company. It’s clear that 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?
Here are a few things to know about applying for a home equity loan, line of credit or a cash-out refinance. Learning about how to get home equity out of your house can help you decide which of these options (if any) is right for you.
How to calculate the equity you have in your home
Your home equity is the difference between the appraised value of your home and how much you still owe on your mortgage. In layman’s terms, it represents the amount of your home that you actually own. For example, if your home is appraised at $200,000 and you owe $120,000, then you have $80,000 of equity in your home. The rest (your mortgage balance) is the part of your home still owned by the bank.
Remember that lenders will still impose a maximum amount you can borrow, often 80 or 85 percent of your available equity — so a new loan or a refinance makes the most sense if the value of your home has increased or you’ve paid down a significant portion of your mortgage.
You’ll have more financing options if you have a high amount of home equity. Borrowers generally must have at least 20 percent equity in their home to be eligible for a cash-out refinance or loan, meaning a maximum of 80 percent loan-to-value (LTV) ratio of the home’s current value.
Calculating loan-to-value (LTV) ratio
In order to calculate your loan-to-value (LTV) ratio, take the amount of your existing or new loan and divide it by the appraised value of your home. Using the above example, you would divide your mortgage balance ($120,000) by your home’s appraised value ($200,000) to find your LTV: 60 percent.
An LTV of 60 percent means you have 40 percent equity in your home, which generally means you’ll qualify for a refinance or a loan.
4 ways to increase your home equity
By owning more of your home, you’ll be able to increase the amount of money you can borrow. If you still owe a large portion of your mortgage, there are a few ways you can build home equity to maximize the amount of money you can take out of your home.
1. Pay off your mortgage
The single most effective way to increase your home equity is to pay off your mortgage faster than anticipated. If you can’t afford to pay off your remaining mortgage in full, try making larger monthly payments, or even just a few extra payments per year. Not only will that help you build home equity faster, but you’ll be saving thousands of dollars in interest. Before you do this, check with your mortgage lender to make sure there isn’t a penalty for paying off your mortgage early.
How this affects equity in your house: Making extra payments to your mortgage principal is the most straightforward way to increase your home equity. Every dollar you pay early toward your mortgage is one dollar of your home equity increased.
2. Increase the value of your home
Another great way to build home equity is to increase the value of the property. You could invest in interior remodeling, landscaping, solar panels or technology to make your home more energy efficient. Before deciding to spend on a remodelling project, make sure the improvements will give you a high return on investment (ROI). Fixing up the kitchen, building a patio and replacing the roof are great ways to increase the value of your property.
How this affects equity in your house: By increasing the value of your home, you can increase your home equity, even without changing the amount that you owe. However, remember that overall market conditions can have an effect on your home’s value, too.
3. Refinance to a shorter loan
If you can afford to pay more for your monthly mortgage payments, consider refinancing to a shorter-term loan. For example, if you currently have a 30-year mortgage, think about switching to a 12-year mortgage so you can pay off your mortgage sooner and build home equity at the same time. However, keep in mind that refinancing your mortgage to a shorter term will increase your monthly payments, so make sure you can afford to cover the added cost every month before refinancing.
How this affects equity in your house: When you refinance to a mortgage loan with a shorter term, less of your payment goes toward paying down the interest. That means more of each monthly payment goes toward paying down your mortgage principal, which increases your equity.
4. Improve your credit score
Although building your credit score won’t necessarily boost your home’s equity, it will give you the opportunity to take out more money. Regardless of how much of the home you own, if you have a poor credit score, you’ll be severely limited in the amount you can borrow. Lenders view homeowners with bad credit scores as high-risk and less likely to be able to repay a loan. Paying your bills on time and keeping credit card balances low can help you improve your credit score.
How this affects equity in your house: Improving your credit score won’t directly affect your equity, but it does have an impact on what kinds of loans you will qualify for. If you’re able to raise your credit score, you may be able to qualify to take out 80 percent of your equity instead of only 70 percent.
Different types of home equity loans
Home equity loans, home equity lines of credit (HELOCs) and cash-out refinances all have their own benefits and drawbacks. Before taking out a loan, it’s important to determine which type is best for your needs.
- 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, the home equity lender is 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.
- Cash-out refinance: These loans are a mortgage refinance for more than the amount owed, where the borrower takes the difference in cash. These are commonly used as a tool in remodels. Buyers can take a short-term construction loan and then use the cash-out refi on their home’s new, higher value to repay the construction costs.
Is it a good idea to take equity out of your house?
Many people have a decent percentage of their total net worth tied up in the equity in their personal residence. While it’s not always a great idea to have so much money tied up in an illiquid asset (your home), whether or not you should be taking equity out of your home often depends on what you are doing with it.
Some people use home equity loans as a way to consolidate unsecured, high-interest debt and drop overall payments. Another use for taking equity out of your home is for a remodel or home improvement project. These kinds of goals usually come with set budgets that make it easy to anticipate the amount you want to borrow.
Before taking out a loan or a cash-out refinance, first evaluate your budget. If you are refinancing to a shorter loan term, you’ll have to make sure you can afford the higher monthly payments. Similarly, if you take out a home equity loan in order to consolidate debt, it’s important to make sure that you have a plan in place to avoid racking up even more credit card debt while you’re paying off your new loan.
Other considerations when getting a home equity loan
While the most important thing is to evaluate your own finances when tapping home equity, there are a few other considerations to be aware of.
Home equity rates are relatively low
Home equity loans and home equity lines of credit (HELOCs) carry much lower rates than credit cards and other types of loans, and they may be easier to qualify for. This is because home equity loans are “secured” loans, meaning they use your home as collateral in case you fall behind on payments.
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 the value of their home sank and their mortgage amount was more than their home was worth.
“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 low, you have to ask yourself how wise it is to borrow against your home at a rate that’s considerably higher than that of 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.
“The risks of getting home equity loans are big because your house is the collateral,” Dunbar says. He recommends that you know exactly how much you need and try to repay it as soon as possible.
If you are considering borrowing equity from your home, your first step is to approximate how much your home is worth. Then take your existing mortgage balance and divide by your home’s value to figure out whether you are eligible.
Make a plan for why you want to take equity out of your house and how and when you’ll pay it back. It’s best if you only take equity out of your home for a specific purpose that has a positive financial payback. This could be anything from consolidating other debts with a lower interest rate to improving your home’s value through a major home improvement project.
Finally, determine whether a home equity loan, home equity line of credit or cash-out refinance is best for you. Then shop around with a few lenders to get the process started.
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