Home Equity Guide

Home equity is the portion of your home’s value that you own, and it may be your largest financial asset. So, it’s good to understand how to use that asset.

Home equity is the current value of your home after subtracting any money you owe on that home. One way to think of it is that home equity is the amount of the property you own free and clear of any debt obligations.

There are a few different ways of converting home equity into cash to meet financial needs. This article will explore those methods, including:

• Home equity loans
• Home equity lines of credit (HELOCs)
• Cash-out refinance mortgages.

Knowing your options and what determines how cost-effective each is will help you make better decisions about potentially using home equity. 

What Is Home Equity?

Home equity is the value of your home above and beyond what you owe on it. But what exactly determines how much that value is?

Here are four things that determine how much home equity you have: 

1. How much you borrowed when you bought your home. Your mortgage reduces the amount of home equity you have. So, the more you borrowed initially, the less home equity you started with. Your down payment gives your home equity an immediate jump start.
2. How much principal you’ve repaid. As you pay off your mortgage, you steadily contribute to home equity. The interest portion of your payment does not reduce your loan balance. But the principal part does, and that increases your home equity.
3. Subsequent borrowing against your home. When you have a mortgage and then add a home equity loan, you reduce your home equity. Any time you increase your total home loan balances, home equity declines. 
4. The market value of your home. Home equity isn’t based on your original home value but on what that property is worth today. According to the S&P CoreLogic Case-Shiller US National Home Price Index, the average home's value has more than doubled over the past ten years. That means a lot of homeowners should be sitting on quite a bit of home equity by now. 

Using Home Equity

If you’ve been in your house for several years, you may have built up a fair amount of home equity. That equity is an asset that contributes to your net worth, but how do you use it?

Essentially, there are two ways you can use home equity. You could sell your home, or you could borrow against its equity.

Selling your home is the ultimate way of cashing in your home equity, but it may not be a desirable option. After all, you may enjoy your home and want to stay in it. Also, while selling a home may cash in the equity you’ve built up in it, you’d now face the expense of paying for new housing.

Many people choose to access their home equity by borrowing against it. This can be somewhat of a have-your-cake-and-eat-it situation. You get to use the financial value built up in your home while still getting to stay in that home.

That advantage can make home equity loans attractive, but they come with financial responsibilities.

When using home equity, it helps to understand loan options and the terms lenders offer you.

Types of Home Equity Loans

What is home equity financing? There are four ways to borrow against home equity. 

Home equity loan

This is often referred to as a second mortgage. It acts much like a primary mortgage in that a home equity loan uses the property as collateral, and you repay it over a predetermined term. 

Home equity loans are installment loans, which means you receive a lump sum when you close your loan and you repay it in monthly installments until the balance is zero. Most home equity loans have fixed interest rates and payments, which makes budgeting easier.

HELOC

As the name suggests, a home equity line of credit is credit available you can tap as needed. As a practical matter, this works somewhat like a credit card. 

With a regular home equity loan, you borrow the money all at once and start owing interest on it immediately. With a HELOC, you establish the line of credit upfront and access this money when you need it, only paying interest on what you borrow. You will generally also pay a fee to maintain the line of credit, but this is usually a fairly modest amount.

Besides the flexibility to access money when you need it, HELOCs are also like credit cards in that you have some leeway as to how much you pay back each month. Of course, if that means it takes longer to pay the money back, you will pay more interest.

The key difference between a HELOC and a credit card is that the HELOC is secured by your home. That means you must be especially careful not to borrow more than you can afford to pay back because you’re putting your home on the line.

Cash-out refinancing

The third type of loan against home equity is a cash-out refinance loan. This entails replacing your existing mortgage with a new, larger loan and taking the difference in cash. 

You can also refinance to lower your monthly payments by switching to a longer-term loan, but this means paying more interest in the long run. 

Cash-out refinancing can allow you to kill two birds with one stone. You can save money on your current mortgage by lowering your interest rate while also tapping into home equity with a portion of the same loan. 

However, cash-out refinancing can be very expensive if you’re only looking for a little extra cash. That’s because lenders apply a surcharge for cash-out refinancing and that charge applies to the entire loan, not just the cash-out. If you borrow $450,00 and only $20,000 is cash-out, a 1% fee comes to $4,500.  That’s 22.5% of your cash. 

Reverse mortgage

Reverse mortgages are special types of home equity loans for people 62 and over. The most popular reverse mortgage is called a home equity conversion mortgage, or HECM. When you take out a reverse mortgage, you can get your proceeds in a lump sum, line of credit, or monthly payments. 

You do not have to pay a reverse mortgage until you leave the home. At that point, you or your heirs can sell the home, pay off the reverse loan and keep any remaining proceeds from the sale.

What Impacts Home Equity Loan Rates

Home equity loans may involve some fees upfront, plus ongoing interest on the amount you borrow. Over time, interest is likely to be the biggest expense involved in borrowing against home equity.

Here are some things that are likely to impact your home equity loan rate:

• Your credit history. The stronger your credit, the lower your rate.
• Income stability. If you’ve held down a steady job for at least a couple years, you’ll be viewed more favorably by lenders.
• Loan-to-value ratio. Your mortgage balance divided by your current home value equals your loan-to-value ratio. The lower this ratio is, the more equity you have. This gives lenders more of a cushion and more confidence to offer you a lower interest rate.
• Debt-to-income ratio. Your debt-to-income ratio equals the total of the monthly payments on all of your debts (mortgage, credit cards, auto loans, etc.) divided by your gross (before-tax) monthly income. Borrowers with lower debt-to-income ratios present less risk and may be offered lower rates.
• Length of repayment period. Generally speaking, the longer the loan term, the higher the interest rate.
• Interest rate trends. Besides factors specific to your situation, interest rates rise and fall depending on market conditions. 

Pros and Cons of Using Home Equity

Compared with other forms of borrowing, using home equity has its pros and cons, as described below. 

3 Things to Do Before You Take Out a Home Equity Loan

Here are three things to do to increase your chances of using home equity successfully:

1. Shop for the best terms. Lending is a competitive business. Use this to your advantage by comparing different offers.
2. Budget for your monthly payment. Always budget before you borrow. Just because you have home equity to borrow against doesn’t mean you have the cash flow to keep up with the payments.
3. Consider the length and total cost of the loan. Review an amortization schedule of principal and interest payments to judge the long-term impact of borrowing against home equity. Look at the total amount of interest you’ll pay over the life of the loan. Think about whether having to make those payments for years to come might impact other goals like saving for retirement or sending kids to college.

See If a Home Equity Loan Suits Your Needs

Home equity loans can be a useful financial tool. As with all financial products, the wisdom of using this tool comes down to specific terms. 

Fees, interest rates, and the affordability of the loan payments should all be keys to your decision. 

You won’t know what terms lenders will offer until you compare quotes from competing lenders. If you need a relatively low-cost form of financing, look into whether a home equity loan could offer attractive terms for your situation.