As a homeowner, you have a few options for taking equity out of your home. You can choose from different types of home loans such as home equity loans, home equity lines of credit, or HELOCs, and cash-out refinances, all of which have advantages and disadvantages to consider.
Tappable home equity is near all-time highs, with homeowners gaining a collective $3.6 trillion in home equity year over year in the second quarter of 2022, an increase of almost 30%. That means now could be a good time to think about borrowing against your house to access cash at a relatively low interest rate.
The type of loan that’s right for you will depend on your personal financial situation and such factors as your credit score, your income and how much equity you’ve already accumulated in your home.
Ways to take equity out of your house
There are three main ways you can unlock your home equity and turn it into cash for such purposes as home renovations and remodeling or consolidating debt. It takes about five to 10 years to build up 15% to 20% of home equity for most homeowners.
“Home equity borrowing is typically less costly than other borrowing alternatives,” says Greg McBride, chief financial officer at Bankrate, CNET’s sister site. “But it is still borrowing.”
- Home equity loan: A home equity loan provides you with a lump sum of cash upfront at a fixed-interest rate on a fixed repayment schedule. This means you’ll have predictable payments over the lifetime of your loan, and even if interest rates continue to climb as expected, your personal rate won’t increase.
- HELOC: A HELOC, on the other hand, is a revolving line of credit that functions like a credit card. You can make repeated withdrawals over time (instead of receiving one lump sum), but your loan will have a variable interest rate, which may not be ideal in today’s rising interest rate environment, because it’s likely your personal rate will go up as market conditions fluctuate.
- Cash-out refinance: A cash-out refinance doesn’t require you to apply for a second loan against your house like a home equity loan and a HELOC (which are commonly referred to as second mortgages). Rather, a cash-out refi replaces your existing mortgage with a new mortgage that has a lower interest rate and new terms. But as a result of the Federal Reserve raising the benchmark interest rate five times this year, the number of homeowners who are candidates for refinancing is at an all-time low.
Determine how much equity you have in your house
Your equity is based on the current appraised value of your house, so you’ll need to have a home appraisal conducted in order for a lender to determine how much of your available equity it will let you borrow against. Most lenders typically want to see at least 15% to 20% equity built up in your home.
All you need to do is subtract your remaining mortgage balance from the current appraised value of your home to calculate your home equity. If, for example, you owe $280,000 on your mortgage and your house is worth $400,000, then you have $120,000, or 30% equity in your home. Try using a home equity calculator to see whether you have enough equity to qualify for a loan.
How to calculate your loan-to-value ratio
Next, you need to figure out how to calculate your loan-to-value ratio, or LTV ratio, which is simply your outstanding mortgage balance divided by your home’s current value. The calculation for that $400,000 property would be:
$280,000 / $400,000 = 0.70
You have a 70% LTV ratio in this case. A typical lender will let you borrow around 75% to 90% of your available home equity. To figure out how much that will be, do the following calculation, which assumes a lender is letting you borrow up to 85% of your home equity:
$400,000 [current appraised value] x 0.85 [maximum equity percentage you can borrow] – $280,000 [outstanding mortgage balance] = $60,000 [what the lender will let you borrow]
Your combined loan-to-value ratio, or CLTV ratio, is your mortgage balance divided by all of your mortgage liens combined if you’ve taken out other loans against your home in addition to your first mortgage. Most lenders prefer a CLTV of 85% or lower.
Determine how much money you want to take out of your house
Depending on what you’re using your funds for, you’ll need different amounts of money. A small home office renovation, for example, may only cost $20,000 and take two months, but if you’re using a HELOC or home equity loan to pay off college tuition over four years and need $300,000, you’ll need a much larger loan amount and an extended repayment period. Lenders will offer different rates and terms, so make sure to shop around and compare rates to get the best deal for your personal financial situation.
What are the benefits of taking money out of your house?
When used responsibly, a home equity loan can help you get out of debt, or pay for a major life expense, by financing it at a low interest rate that you may not get with other types of loans, such as a personal loan or paying with a credit card. Plus, if you use the funds to renovate your property, you’re increasing the value of your home, which ultimately increases your net worth.
What are the risks of taking money out of your house?
Your home is on the line when you take out any type of home equity loan, which is no small consideration. When your house is used as collateral to secure your loan, it allows your bank or lender to offer you a lower interest rate than an unsecured loan, such as a personal loan.
Lower rates are great, but that means if you miss payments or default on your loan, your lender can repossess your property or foreclose on your house. That’s why it’s especially important to consider whether you can responsibly manage a high line of credit over a long period of time, and if home equity loans are a wise choice for you.
“Taking money out of your home isn’t the same as going to the ATM and taking money out of your bank account,” says McBride. “This is borrowing, which must be repaid in full, with interest, and using your home equity as collateral in the event of default. Some homeowners look at home equity as ‘found money’ but there is no free lunch here -- this may limit your financial flexibility by adding another monthly payment to your budget,” McBride adds.
If your property goes into foreclosure for any reason there can be long-term negative effects:
- Your credit score can drop by as much as 100 points.
- A foreclosure can remain on your credit report for seven years.
- A lender may decline your application to borrow money for several years.
- You could get a deficiency judgment.
However, lenders and banks may be willing to work with you to help you pay back the loan, as it benefits them to continue receiving payments from you rather than trying to sell your home to someone else.
Other factors to consider when taking equity out of your house
There are other considerations to keep in mind when you tap your house for equity:
- Home equity rates are low: Rates are likely to keep increasing, as the Fed is expected to raise interest rates one more time before the end of the year, which continues to make home equity loans and HELOCs look appealing to homeowners who need cash quickly. Right now, the average rate for a HELOC is 7.30% and the average home equity loan rate is 7.29%, according to Bankrate. Compare that to personal loans, which have an average rate of 11.20% right now.
- Home values can diminish: Even though rates are low, as the housing market continues to cool and a recession looms, your house could be more vulnerable to dipping into negative equity (although that’s unlikely to happen anytime soon, as home prices have risen 42% since the beginning of the pandemic).
- Your house is on the line: Your property secures your loan, so if you can’t pay back your loan, your lender is entitled to take ownership of your house and use your property to pay itself back the money you owe by putting it up for sale.
- Borrowing is more expensive now: Although home equity rates are lower than other rates, it costs more to borrow now than it did earlier this year. “Borrowing rates for home equity are the highest since 2008, so while you may be sitting on more equity than ever, it also costs a lot more to borrow from it,” says McBride. “Do you want to increase your debt load and add another monthly obligation with a recession very likely on the horizon?”
The bottom line
There’s a record amount of tappable home equity available to homeowners right now and there are multiple ways you can choose to access the equity in your property. Figure out how much equity you’ve built up, get quotes for your potential interest rate and explore your home loan options such as home equity loans, HELOCs or cash-out refinance.
No matter what type of financing you choose, it’s important to interview multiple lenders to give yourself a better chance of securing a lower interest rate. Shop around and compare offers to see which lender offers you the best deal. It will save you thousands of dollars over the lifetime of your loan, as even one-tenth of a percentage point can significantly affect the cost of your loan.
It can make sense to tap into your home equity while home equity remains at record highs, especially if you have other high-interest debt such as credit card debt that you could pay off at lower interest with a home equity loan. You can save yourself thousands of dollars in interest.
It’ll likely make more financial sense for most homeowners to apply for a home equity loan or HELOC. Because interest rates are so high and continue to rise, a cash-out refinance won’t benefit the majority of homeowners who locked in lower mortgage and refi rates over the past two years.
Yes, you can use a home equity loan for a number of important life expenses such as consolidating debt, cover college tuition or start a small business. But you shouldn’t use your home equity loan to pay off your first mortgage, or for non-essential items such as vacations. What’s more, if you use your loan for home renovation, your interest will be tax deductible.
The simplest way to build home equity is to make consistent and on-time mortgage payments. The longer you’ve been paying off your mortgage, the more home equity you have. Another way to build equity quickly is to make a large down payment.