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You’re feeling the need for some extra cash — with inflation and all, who isn’t, these days? — and it occurs to you a source for it could be within your own home. In recent years, the old homestead has earned plenty of equity, as its fair market value has increased and you’ve faithfully made your mortgage payments, building up your ownership stake. So it can be tempting to tap into it via a home equity loan, HELOC, or cash-out refinance.
Truth is, though, this may not be a good time to pull equity out, even if you have sound reasons. In any event (and at any time) it’s important to understand how to use home equity wisely, and when and how to take equity out of your home. Here’s what to consider when tapping into your home equity, and why you may or may not want to.
What is home equity?
First, a quick refresher in residential value. Home equity is simply the portion of your property you’ve paid off — the amount or percentage of it you own outright. It’s the difference between your home’s appraised/current market value and your outstanding mortgage loan balance. Put another way, it’s the amount you would pocket (before closing costs) in a home sale after paying off what you owe to your lender.
When you borrow to buy a home, your equity stake is comparable to the down payment you make — the actual cash you contribute to the purchase. The larger your down payment, the larger your equity share. Then, over the years, you build more equity as you pay down your mortgage loan’s principal balance. Implementing home improvements that up your home’s resale value is another way to build equity. If your home’s fair market value — the price it would fetch if you listed it tomorrow — also appreciates, your equity climbs, too.
How do you tap into home equity?
How to take equity out of your home? There are three primary ways to cash in what you’ve accrued: a home equity loan, home equity line of credit (HELOC), or cash-out refinance of your existing mortgage loan.
A HELOC works as an adjustable-rate revolving line of credit that lets you tap your home’s equity as cash for any purpose you desire. It’s somewhat like using a credit card — only, instead of your debt being unsecured (as it is with plastic), you’ll be required to put your home up as collateral for a HELOC. As with a credit card, you borrow what you need at a time of your choice (though there’s a finite draw period), repay what you owe, and borrow again if you choose.
With a HELOC, your credit limit will be based on your available home equity; you can typically borrow up to 85 percent of the value of your home (not counting your unpaid mortgage balance). During the draw period (often the first 10 years), you’ll be required to pay monthly interest on any amount you borrow, but your funds will be replenished as you repay the HELOC. During the repayment period, funds are no longer accessible and you’ll be obligated to repay the principal and interest over 10 to 20 years, on average.
“This is one of the most common ways homeowners access their equity. Many people use a HELOC to make a major purchase, do a home renovation, or for debt consolidation. It’s typically more affordable than a cash-out refinance, and the rate and limit are much more attractive than a personal loan or credit card,” says Seth Bellas, branch manager for Churchill Mortgage. “However, a HELOC also has a variable interest rate that changes as the prime rate shifts, so [the outstanding balance] can increase rapidly. Many homeowners find it difficult to stay disciplined in paying down the principal on their line of credit, which can make for a significant interest expense down the road.”
With a cash-out refinance (refi for short), you take out a new and bigger mortgage to replace your existing one. The difference between the two loan amounts is the cash you’ll pocket at closing, which equates to some of the equity you’ve accrued in your property (your lender may require you to keep at least 20 percent equity in your home). Your new loan’s outstanding principal will be higher than that of the loan it is replacing, but you can opt for a shorter or longer term.
“For example, if you owe $100,000 on a home that’s worth $200,000, you can take out a new mortgage for $150,000 and take the remaining $50,000 of equity as cash,” says Rick Sharga, executive vice president of Market Intelligence for ATTOM. “But it’s important to realize that this will increase your debt, from $100,000 to $150,000 in this example, and will generally result in you paying more interest over time.”
You’ll also have to pay closing costs, as you would with most refinances.
Home equity loan
A type of second mortgage, a home equity loan is a sum you borrow, obtained using the equity in your home. As with the HELOC, your home becomes collateral for the debt (meaning you could lose it if you don’t repay the loan); unlike the HELOC, you borrow a set amount, which is paid out in a lump sum at closing.
“Using the previous homeowner example, they could borrow $50,000 against the equity in their home and begin making monthly payments on the second loan in addition to their primary mortgage loan’s monthly payment,” Sharga says. Terms vary, but home equity loans can be repaid over as long as 30 years.
“A homeowner who has a very good interest rate on their current mortgage loan might consider this option rather than a cash-out refinance, as the latter could charge a higher interest rate,” Sharga continues. Lenders often charge a lower interest rate for home equity loans compared to the rates on personal loans and credit cards. “But second mortgages tend to have higher interest rates than primary mortgages, so borrowers should factor this in before using this option.”
Reasons to consider not tapping into your home equity
Just because you can tap your home equity, qualifying for any of the methods above, it doesn’t mean you should — even if you intend to use the money wisely, such as toward a home improvement project that will increase your property’s resale value. Some of the reasons have to do with the current economic climate, and some are more evergreen, relating to personal finances.
Interest rates are high and volatile
Ponder this reason for postponement: Borrowing money is very expensive right now, more expensive than it’s been in nearly two decades.
Mark Hamrick, senior economic analyst and Washington bureau chief for Bankrate, cautions that current higher interest rates on home equity financing options will likely result in severe sticker shock if you pursue one of them.
“One of the shocking aspects of the financial environment this past year has been the sharp rise in mortgage rates and many other loan products, coinciding with the Federal Reserve’s decision to tighten monetary policy,” he says. “We may have seen a peak in mortgage rates, but confirmation on that will require a bit more time.”
Consider that interest rates for a fixed-rate cash-out refinance tend to be higher than for primary mortgage loans or rate-and-term refis. The same is true for home equity loans and HELOCs.
“Keep in mind that HELOC rates increase every time the Federal Reserve adjusts the federal funds rate. It’s risky to take on a debt that, in the short term, will only grow more expensive because of inflation,” cautions Bellas.
Word is, the Fed will continue to increase interest rates in 2023, too. It might be better to wait until the numbers stabilize.
You’ll be adding to your overall debt load
Another reason to kick a home equity tap down the curb is that you’ll be piling on to your total debt, possibly making it more challenging to afford repayment of all of your unpaid balances in the months and years ahead.
“Tapping into equity increases your overall debt and what you will owe your lender — both in principal and interest — over time. So it’s important to weigh short-term benefits versus long-term costs,” notes Sharga.
Hamrick is concerned that, if the economy stumbles in the months ahead, job loss and interrupted incomes can cause difficulty for many individuals and households. “Taking on even more debt can be a less-than-optimal decision under these circumstances,” he says.
Most HELOCs only require you to pay down the interest every month, similar to how a credit card has a minimum payment that doesn’t reflect your overall debt. By the time the full repayment is due, you will have not only your principal to pay back, but also interest on that principal, making it a pretty steep hill to climb if you aren’t in a great financial position.
— Seth BellasBranch manager for Churchill Mortgage
An unpredictable housing market is impacting home values
If you’ve followed the residential real estate scene closely over the past year, you’ll know that the long-running go-go sellers’ market has slackened in many parts of the country. “Home prices have declined in some markets and home sales have declined,” Hamrick points out. In addition, while “there is a high degree of uncertainty around these issues,” the trend is towards a slower, more balanced market: The days of bidding wars and homes fetching almost any price you care to ask are over, most analysts feel.
The latter is a cause for concern among homeowners who may overestimate their home’s appreciation. No longer can they count on its market value rising steadily, as it has in the past two pandemic years. In fact, very possibly the opposite.
“Homeowners need to be careful in light of a possible recession and home values potentially stagnating or declining in value,” Bellas warns. There is always risk involved in taking equity out of your home, but it’s especially keen if your local market prices are moving into negative territory, Sharga emphasizes. “You might ultimately find yourself owing more than your home is worth,” he notes.
You’re laying your home on the line
There’s a good reason the interest rates on home-loan products are more favorable: The debt you rack up is secured (that is, backed by something) — namely, your home. But that also makes the risk greater. Defaulting or being delinquent on other debts is unpleasant and louses up your credit report and score, but that’s it. Here, on the other hand, you’re essentially mortgaging your property, which is probably the biggest single asset you have. Sharga says, ask yourself: Is it worth possibly losing your home to foreclosure in the event market conditions worsen or your personal financial situation deteriorates?
Tips for tapping into home equity
If you are seriously pondering cashing in some of your home’s equity, proceed with caution.
“Don’t treat home equity like it’s an ATM for purchases you don’t really need to make,” advises Sharga. “Homeownership is a proven way to build up long-term wealth – even providing financial security for multiple generations – and shouldn’t be wasted on frivolous things. Funds should be used judiciously for things like home improvements, paying down higher interest rate debt, or education.”
Hamrick says homeowners in the best position to use home equity are those who have accumulated a substantial amount of it — meaning the value of their home is much higher than the amount remaining to be paid off on their mortgage.
“This typically includes people who have been in their homes for a long time and have not often refinanced. They should also have a high degree of confidence about their job and income security,” he adds. “Those who have only been in their homes a short time should wait until they enjoy a higher level of home equity.”
Final word on tapping into home equity
You should always do your due diligence and consider carefully before committing to a HELOC, home equity loan, or cash-out refinance. Think carefully about your reasons, especially if you want the funds to pay off student loans or credit card balances: Are you basically clearing old debt with new debt? That can be a trap, especially if it means risking an asset like your home.
In addition, many financial experts are concerned about a recession and unpredictable interest rates in the coming months. “This is a time for people to be extra careful with their personal finances. We should make emergency savings and paying down debt a priority,” recommends Hamrick. “Taking on a substantial amount of extra debt comes potentially more problematic during times like these.”
Despite all this, drawing out your home equity still might work for you. But weigh the pros and cons carefully before you tap the keg.