Homeowners in the United States with mortgages have recently seen the equity in their homes grow substantially: In the fourth quarter of 2021, home equity increased year over year by a total of more than $3.2 trillion since the fourth quarter of 2020, according to real estate data and analytics firm CoreLogic.
With all this extra home equity, many homeowners have the option to unlock cash that they need—without having to sell their homes or take out expensive personal loans. Instead, they can tap into their equity through a home equity loan, a home equity line of credit (HELOC), or a cash-out refinance.
Key Takeaways
- Home equity is the difference between a property’s current market value and the amount owed on the mortgage.
- Home equity loans, home equity lines of credit (HELOCs), and cash-out refinancing are the main ways to unlock home equity.
- Tapping your equity allows you to access needed funds without having to sell your home or take out a higher-interest personal loan.
- Lenders impose borrowing limits (often 80% to 85% of your available equity), so a loan or a refi makes the most sense if you’ve paid down a sizable portion of your mortgage or if your home’s value has increased.
- You can build equity in your home by making a larger down payment, making larger or extra mortgage payments, and adding value through remodeling and home improvement projects.
Home Equity Loan
A home equity loan is a second mortgage for a fixed amount that is repaid over a set period, such as 15 years. Home equity loans are amortized at the beginning, and each payment is divided between interest and principal (in the same manner as a primary mortgage). The loan cannot be drawn upon further once it is issued.
This type of home loan is the most structured, and it mirrors a primary mortgage. However, a home equity loan typically has a slightly higher interest rate than a primary mortgage. That’s because the primary lender is the first to be repaid through sale proceeds if the home is foreclosed—so the home equity lender has added risk.
Home Equity Line of Credit (HELOC)
A home equity line of credit (HELOC) provides the most flexibility. This type of loan is a second mortgage with a revolving balance: You borrow only what you need, pay it off, then borrow again. It works in the same manner as a credit card but with significantly lower interest rates. Your payment is based on the amount of credit that you use rather than the available loan amount. Most lines of credit come with a checkbook or a debit card to provide easy access to funds.
Unlike the other two forms of secondary home loans, HELOCs usually come with no closing costs. Also, HELOCs have adjustable rates that vary with the prime rate, meaning that your rate could rise or fall over the life of the loan. HELOC rates are often discounted at the beginning of the loan term and then increase after six to 12 months.
HELOCs are typically divided into two stages: the draw period and the repayment period. The draw period is typically five to 10 years, during which time you can withdraw money up to your line of credit and make interest-only payments. During the repayment period, the final amount that you’ve withdrawn becomes a loan to be repaid with interest, and within a specified time period (often 10 to 20 years). During this time, you can no longer draw against the account.
Cash-Out Refinance
Unlike the other two alternatives, cash-out refinancing does not necessarily involve a second loan. It is often used to provide additional funds to a homeowner. In this case, you refinance your home for a larger amount, which allows you to take the difference in cash.
The closing costs for a cash-out refinance can be rather high in some cases, because you end up with less equity in your home than you had before. For this reason, some banks might consider you as a riskier borrower.
What Is the Best Way to Tap Home Equity?
The smartest strategy for accessing your home equity depends mostly on what you want to do with the money. Of course, your credit score and your financial situation matter, too. However, they will be factors regardless of which option you choose. These choices usually match with the situations and goals listed below.
For lump-sum expenses or debt consolidation
The main advantage of a home equity loan, or second mortgage, is that all of the money is disbursed at the outset. Unsurprisingly, many borrowers who apply for a second mortgage have an immediate need for the entire balance.
These loans are often used to pay for educational expenses, medical fees, other lump-sum expenses, or debt consolidation. The interest rates for second mortgages are usually much lower than for credit cards. For homebuyers who are interested in saving money through debt consolidation, a home equity loan can be a good option.
For home improvements or launching a business
A HELOC is a good fit for homeowners who need access to cash periodically over a span of time. These expenses are usually incurred on an ongoing basis. A HELOC can be used for a series of home improvements, for example, or for launching a small business.
HELOCs are generally the cheapest type of loan because you pay interest only on what you actually borrow. There are also no closing costs. You just have to be sure that you can repay the entire balance by the time that the repayment period expires.
During the coronavirus pandemic, most banks have still been offering these loans, but some raised their requirements for credit scores and loan-to-value (LTV) ratios. In addition, Wells Fargo and JPMorgan Chase instituted freezes on applications for new HELOCs, which remain in place as of May 2022. (The freezes don’t affect those who already have HELOCs.)
To pay off car loans or credit cards
A cash-out refinance can be a good idea if your home has gone up in value. It is often the best option if you need cash right away and you also qualify to get a better interest rate than on your first mortgage.
If your credit score is much higher than when you purchased your home, then a lower rate can help offset the higher payment that will come with a larger balance that includes the cash-out amount. If you use the cash-out amount to pay off other debts, such as car loans or credit cards, then your overall cash flow may improve. Your credit score may even rise enough to warrant another refinance in the future.
It is often a good idea to speak with a qualified credit counselor before applying for a loan.
How do I calculate my home equity?
Home equity represents your ownership stake in the home. To calculate your home equity, subtract your mortgage balance (and any other liens) from the property’s current market value. For example, if your home is currently valued at $400,000 and you owe $150,000, then you have $250,000 in home equity.
Can I deduct home equity loan or home equity line of credit (HELOC) interest?
The Tax Cuts and Jobs Act (TCJA) of 2017 changed the criteria. The interest charged is now deductible only if the loan is used to “buy, build or substantially improve” the home that is collateral for that loan. If the loan is used for those purposes, then a taxpayer can deduct interest on up to $750,000 of borrowing. This limit covers all real estate debt, including your primary mortgage(s).
How much equity can I cash out?
Lenders impose limits on the amount that you can borrow—typically 80% to 85% of your available equity. For example, if you have $250,000 in equity, the lender may let you tap 80% of that, or $200,000.
How can I build equity in my home?
Your home’s equity increases as you pay down your mortgage and when the property’s value increases. To pay down your mortgage faster, you can increase your down payment and pay down the principal by making larger and/or extra mortgage payments.
To increase your property’s value, you can invest in remodeling and home improvement projects. However, it’s important to focus on improvements that actually increase the value of the home. For example, a kitchen update generally adds value to the home, but a swimming pool may be viewed by potential buyers as a safety risk and a maintenance headache.
Mortgage lending discrimination is illegal. If you think that you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps that you can take. One such step is to file a report with the Consumer Financial Protection Bureau (CFPB) or the U.S. Department of Housing and Urban Development (HUD).
The Bottom Line
Many homeowners believe that selling their house is the easiest and most convenient way to get a needed cash influx. Even homeowners who own other types of assets may find this strategy appealing if they want to avoid selling taxable holdings that would trigger capital gains taxes or withdrawal penalties on early individual retirement account (IRA) or retirement plan distributions. However, accessing your home equity can be a smart way to borrow—without having to sell your home, take out expensive personal loans, or rack up credit card debt.
Home equity debt is not a good way to fund recreational expenses or routine monthly bills. However, it can be a real lifesaver for anyone saddled with unexpected financial challenges. Home equity debt can also be a good way to invest in the future. The key is to make sure that you borrow at the lowest possible interest rate—and keep in mind that borrowers who do not repay these loans can lose their homes in foreclosure.
