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?
How to determine how much equity you have in your home
In short, 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. Generally, you’ll have more financing options if you have a high amount of home equity. A lender will look at the amount of home equity you have in order to determine your loan-to-value ratio (LTV).
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 get $40,000 ($100,000 − $60,000 = $40,000) — that’s the amount of equity you can borrow from your home.
Keep in mind that banks can 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.
Additionally, 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.
Different types of home equity loans
Home equity loans, home equity line of credit (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.
- Cash-out refinance: 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 much equity should you 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.
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, it is suggested to go 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.
If you’re looking to tap the value in your home, learn more about the requirements to borrow from your home equity.
How to increase your home equity
By owning more of your home, you’ll also 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.
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.
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. But 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.
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.
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. But paying your bills on time and keeping credit card balances low can help you improve your credit score.
Other considerations when getting a home equity loan
Home equity rates are still low
Home equity loans and home equity line of credit (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.
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.
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.
“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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