Research from Black Knight shows that homeowners in the U.S. had $6.5 trillion in equity borrowing potential as of the first quarter of 2020 — an all-time high. Clearly there are opportunities for many homeowners to get a home equity loan, home equity line of credit (HELOC) or 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 cash-out refinance. Learning about how to get 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.
How to take equity out of your house
There are various ways to take equity out of your home. They include home equity loans, home equity lines of credit (HELOC) and cash-out refinances, each of which have benefits and drawbacks.
- 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 or so years, the line of credit is open and all debt payments are interest-only. The loan then converts to a repayment plan of around 20 years that includes the 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.
Benefits of taking equity out of your house
One of the primary benefits of tapping home equity when you need a significant amount of money is that you can often access the cash at far lower interest rates than with personal loans or credit cards. When you need to cover large expenses such as home renovations, college tuition or debt consolidation, using home equity can be a far less costly way to obtain the funds.
“It’s often the cheapest form of financing available for homeowners,” says Vikram Gupta, head of home equity at PNC Bank. “Because the loan is secured by the house, lenders can offer it at a lower rate compared to other consumer lending products.”
Another primary benefit of accessing money this way is that the interest you pay on a home equity loan or line of credit may be tax deductible. The deduction may be available if you use the money to buy, build or substantially improve your home, according to the IRS.
Risks to consider
While taking equity out of your home does have advantages, it is also not without risk. The primary downside is that your home is used as collateral for the mortgage or equity product.
“What that means is that if you are unable to make the monthly repayments for a sustained period of time there is a risk that the lender could foreclose on (repossess) your house,” says Gupta.
Another concern often associated with taking equity out of your home has to do with the potential for declining home values amid a downturn in the real estate market.
“If home values in a given market are declining, borrowers run the risk of owing more than what the home is worth,” says Jason Salcido, director, consumer direct mortgage sales at PenFed Credit Union.
5 ways to increase your home equity
If you want to borrow from your home equity but don’t yet meet your lender’s threshold, there are a few ways to increase the amount of equity you hold.
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. For instance, you could invest in interior remodeling, landscaping, solar panels or technology to make your home more energy efficient. Before deciding to spend on a remodeling 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. When taking this approach, however, remember that overall market conditions can have an effect on your home’s value, too. And not all renovations will increase the value of your home, so choose improvements wisely.
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.
5. Take advantage of market fluctuations
Granted, this is a less proactive approach, but real estate markets change over time, and your home value fluctuates accordingly. As demand grows and home prices increase, the value of your home rises. As a result, your home equity increases.
Though this approach is out of your hands, you can be proactive by regularly monitoring and checking the value of your home on sites like Zillow and Redfin.
How this affects equity in your house: The value of your home, and thus the equity you have in it, is impacted by market forces such as increased demand. Regularly checking on the value of your home will help you stay informed so you can be ready to act when the time is right.
Other considerations when getting a home equity loan
If you think you’re ready to use your home equity, keep in mind the following considerations.
- 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.
- 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, especially if the rate you’re now borrowing at is considerably higher than that of your first mortgage. If you fall behind on payments, you’re at risk of foreclosure. 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.
If you’re 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 if you are eligible.
Develop a plan that addresses 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.
Is it a good idea to take equity out of your house?
Many people have a sizable percentage of their total net worth tied up in home equity. 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. Others use equity 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. This allows you to determine whether or not you can afford the additional monthly obligation of paying off the loan.
“If customers have a need for cash or liquidity, taking equity from your home is often the cheapest form of financing available,” says Gupta. “If customers have other sources of cash or liquidity available such as cash, investments or other financial assets, they should weigh the returns they generate on those funds versus the cost of a home loan and make an appropriate risk versus return tradeoff.”
Which is better: Cash-out refinance or home equity loan?
The decision between a cash-out refinance and home equity loan depends on the individual’s needs, says Gupta. “Both products are fairly comparable in terms of the document requirements and processing times. Where they differ is that home equity loans typically don’t have closing costs associated with them while cash out refinances do have closing costs.”
In addition, it’s important to understand that many lenders do not roll taxes and insurance for home equity loans into escrow. As a result, customers may be responsible for paying those amounts separately on an annual basis.
“Customers should ensure they do an apples-to-apples comparison between the two products and include all terms,” says Gupta.