What is home equity and what can it do for you?
You might be hearing a lot about home equity loans right now. With the past year’s historic increases in home values and interest rates rising, it’s a good time to lock in a low rate for a home equity loan, especially if you’re thinking about doing any kind of home renovations or improvements in the near future.
So, what is home equity? It’s the monetary value of how much of your home you own outright. It’s calculated by subtracting your mortgage debt from your home’s current market value. Though home equity isn’t a directly cashable liquid asset, it is part of your net worth and can be leveraged for cash by using your home as collateral for a loan or line of credit.
Accessing your equity for cash can make a lot of sense, especially if you want to use the funds to make home improvements. If you’re making substantial improvements, you may even be able to write off the interest from your taxes.
Renovations are one of the main reasons people choose to take out home equity loans or lines of credit, but they aren’t the only way you can use your money. Unless your lender has specific usage requirements, your home equity is yours to use how you wish. Because home equity loans and lines of credit tend to have lower interest rates than other loans or sources of credit, you may opt to use your home equity for other large one-time expenditures or for expenses that will accrue over a period of time. In addition to home repair, you might consider using your equity to make payments toward education, real estate, vacations, debt consolidation or any other expenses.
It’s important to remember that, while you can spend your money as you’d like, you should also be sure to spend your money wisely. Using your home as collateral means you could lose your home to foreclosure if you can’t repay your loan.
How to increase your equity and net worth
The current market value is always the baseline for determining home equity. Putting a down payment on a home instantly gives you some equity. If you put down 20% of the home’s value, you have 20% equity. Then, as you pay your mortgage over time, your equity increases.
You also gain equity when your home appreciates in value. As home prices rise, your home’s value increases. Because the home is worth more, your net worth is also higher.
In the past year, we saw record spikes in home prices and values. Because of these increases, Washingtonians with mortgages averaged $96,000 in home equity growth from the third quarter of 2020 to the third quarter of 2021. That’s a big leap in net worth for many homeowners.
But what if we’re in a year that doesn’t see such drastic increases in home valuations? In those years (or in any other years), you can choose to increase your equity by making renovations and home improvements that will further increase the value of your home.
How to leverage your equity for cash
There are several ways to access your home equity, and each option comes with its own individual lender’s terms with varying cash availability, interest rates, closing costs and fees, and repayment terms.
Your primary options come in four forms:
- Home equity loans allow you to access a lump sum of money through a loan with a fixed interest rate.
- Home equity lines of credit work like a credit card with a variable interest rate and typically allow you to borrow money for a 10-year period.
- Cash-out refinancing renews your existing mortgage at the current interest rate and pays you the difference between your new debt and old debt.
- Reverse mortgages allow homeowners over the age of 62 to cash in their equity through a loan that is repaid upon death or the sale of the home.
Home equity loans vs. home equity lines of credit (HELOCs)
Home equity loans and home equity lines of credit, also known as HELOCs, are often discussed together. While one is a loan and the other works more like a credit card, both act as second liens on your home if you’re still paying your original mortgage. For this reason, home equity loans are often referred to as “second mortgages,” though both loan types are also available if your mortgage has already been paid in full. In this case, you would have 100% equity in your home.
So, how do you choose between the two?
Home equity loans are good choices when you need a large sum of cash for a single payment, and because interest rates are fixed, you’ll be able to get exact repayment calculations.
HELOCs work similar to credit cards. They have variable interest rates that can change with the market in the same way as regular credit cards. The advantage of a HELOC is that you can access money as you need it, and you’re not charged interest on money that you don’t use. Another advantage is that the interest is often lower than that of regular credit cards, even when it adjusts according to market rates.
Another advantage of both home equity loans and HELOCs is that interest may be tax deductible if the loans are spent making home improvements on the same property that funds the equity loans.
Cash-out refinancing falls under another category of home equity access. Unlike a home equity loan or HELOC, cash-out refinancing is a mortgage loan.
In simple terms, cash-out refinancing gives you the ability to borrow more than you currently owe on your initial mortgage. Some of that borrowed money is then used to pay off the first mortgage; the rest of the borrowed money is given to you in cash.
In most cash-out refinancing situations, you’ll be required to keep at least 20% equity in your home. In the event that you are permitted to borrow enough that will leave you with less than 20% equity, private mortgage insurance may be required.
Because refinancing is technically a new mortgage, it has many of the same fees and closing costs as the original mortgage; however, it may be a good option if it leads to a significant interest rate reduction.
Reverse mortgages are another way of receiving cash from home equity without selling your home.
With a regular mortgage, you make payments to your lender for your home. In a reverse mortgage, the lender makes payments to you for equity in your home, while you keep the title and continue to be responsible for property taxes, insurance, maintenance and other expenses.
There are three types of reverse mortgages:
- Home equity conversion mortgages (HECMs), which are federally insured
- Single-purpose reverse mortgages, offered by state and local government or nonprofit agencies that dictate how funds can be used
- Proprietary loans backed by private companies
Like other types of home equity loans, the lender offers cash based on your home equity and uses your home as collateral. The main difference is the loan doesn’t have to be repaid as long as you continue to live in your home. Instead, loans are due with interest upon death, the sale of the home or when the home is no longer your primary residence.
The biggest risk of a reverse mortgage is the possibility that the total loan amount with interest may eventually exceed the value of the home. This may be particularly true with variable interest rates, making it more difficult to estimate the loan total over an extended period of time. To help mitigate this risk, some lenders may include a clause that prevents your estate from owing more than the value of the home, but if any heirs wish to keep the home, the loan must usually be paid in full.
Choosing the best option
The best way to decide how to access your funds is by talking to a trusted financial advisor and doing the math to see what makes the most sense for your situation. Specific lender terms, interest rates, closing costs and length of loan repayment will create a unique set of advantages and disadvantages for each individual loan.
|Home equity loan||Home equity line of credit (HELOC)||Cash-out refinancing||Reverse mortgage|
|What it is||A new loan distributed in one lump sum||A loan that allows you to withdraw funds as needed, typically for a 10-year period||A new mortgage loan that pays off an old mortgage and pays the difference in cash||A loan received for equity in the home, borrower must be 62 years or older for eligibility|
|Cash available||Depending on credit score, up to 85%-100% of the home's value minus liens and closing costs||Varies according to equity and credit score||Accrued equity minus 20% total equity and closing costs||Dependent on age, type of reverse mortgage, interest rates, and amount of equity|
|Loan period||One-time distribution||Typically 10 years to withdraw||One-time distribution||Fixed monthly cash advances, line of credit or combination|
|Repayment period||Typically 5-20 years||Typically only interest due during draw period (usually first 10 years); remaining principal and interest due during repayment period (usually 10-20 years that follow draw period)||Varies according to lender and individual loan terms||Repaid with interest upon death, sale of home or when home is no longer primary residence|
|Interest rates||Fixed, but may be lower than other fixed-rate loans||Variable, but may be lower than credit card or other variable-rate loans||Fixed or variable rate (Fixed rate may be lower than home equity loan rate.)||Usually variable|
|Fees and closing costs||Yes, but vary||Few, if any||Yes, but vary||Yes, but vary|
|Tax advantages||Interest may be tax deductible when used for some types of renovations and when the equity is from the property that is being improved.||Interest may be tax deductible when used for some types of renovations and when the equity is from the property that is being improved.||You may lose some of the original mortgage tax advantages but may claim deductions for some types of home renovations.||Amount may qualify as tax-free income because funds are from a loan; interest may be tax deductible when loan is paid.|
|When it makes most sense||When making a single purchase or there is a clear estimate of total cost||When needing to access funds over a period of time or when the exact dollar amount needed is unknown||When the loan has a substantially better interest rate than the current mortgage and cash is needed||When cash is needed for retirement and the home is not intended to be left as an inheritance|