It’s tempting, but is it necessary? It’s available, but do I want the consequences? Is it the right move to improve my financial situation or will it take me down a dark hole? Deciding to take the equity out of your house can have both benefits and pitfalls.
Maybe you want to renovate your home to avoid having to buy a new house in today's cutthroat market. Perhaps you wish to pay off higher interest credit card or student loan debt. Whatever the reason may be, if you are interested in tapping into your home's equity, you need to know a few things first.
How much home equity do you have?
The first step in accessing home equity is determining how much equity exists in the first place. Generally, lenders will only allow homeowners to borrow up to 80% of the home's value.
To determine home equity, a homeowner first needs to know the current value of the home. Most, if not all, lenders will require a formal home appraisal with costs generally paid by the homeowner. Bankrate.com estimates the average cost of an appraisal in the U.S. is $300 to $450, depending on location.
Once the appraisal determines the home value, calculate your available home equity. For example, let’s assume your home appraised for $350,000 and you have a mortgage balance of $190,000. Your current home equity is $160,000 ($350k - $190k = $160k). Knowing you can only borrow up to 80% of the appraised value, or $280,000 (80% of $350k = $280k), the total amount you can access is $90,000 ($280k - $190k = $90k).
Do you qualify to borrow?
Most lenders require a minimum credit score. According to Experian.com, a credit score of around 660 is generally acceptable. However, it will vary by lender and by loan option.
In addition, lenders will evaluate your debt to income (DTI) ratios. To calculate, take monthly debt payments (mortgage, car loan, student loan, credit card debt, etc.) and divide by monthly take-home pay. If your DTI ratio exceeds 50%, a lender will be less likely to want to lend you more money.
Which lending vehicle works best for you?
There are three ways to access your home equity: cash-out refinance, a home equity line of credit (HELOC), or a home equity loan.
- Cash-Out Refinance. The homeowner essentially pays off the existing mortgage and replaces it with a new (and bigger) mortgage. Using the earlier example, if your goal is to access the maximum amount of equity in your home, you would take out a completely new mortgage on your $350,000 home for $280,000; payoff your current mortgage balance of $190,000; and receive $90,000 in cash.
The new mortgage loan will have a new payment term (typically 15 or 30 years) and either a fixed or variable interest rate. Keep in mind the homeowner will also have to pay closing costs to establish the new mortgage.
- Home Equity Line of Credit. A HELOC is a separate loan on top of an existing mortgage. The homeowner has access to the line of credit as needed up to a certain amount. The interest rate will be variable and generally higher than the interest rate you have on your first mortgage. Once you access money via the HELOC, a second monthly payment will be required. Again, using the earlier example, you retain your $190,000 mortgage on your $350,000 home. In addition, you have a line of credit available to draw up to $90,000 with the flexibility to use as much or as little as you need.
- Home Equity Loan. Like the HELOC, a home equity loan is a separate loan in addition to the existing mortgage. In our example, you would retain your $190,000 mortgage on your $350,000 home and receive $90,000 lump sum payment upfront. Consequently, you will have a separate home equity loan of $90,000 at a fixed rate and will be required to make a second monthly payment.
One benefit of a HELOC or a home equity loan over the cash-out refinance option is the ability to access equity without taking out a new mortgage. In general, there are little to no closing costs associated with HELOCs and home equity loans. In addition, if the line of credit or equity loan is used for purposes of home renovation, interest is deductible. The interest is not deductible if loan funds are used for any other purpose (debt consolidation, investing, etc.).
What are the risks of tapping home equity?
- Regardless of how you access your home’s equity, your home is the collateral. If it will be difficult to make the new mortgage payment or the additional payment of the HELOC or equity loan, don’t do it. You could end up losing your house.
- If using equity to consolidate debt, i.e. credit cards, there is a temptation to run up credit card debt again. Recreating the high interest debt can result in a dark hole that is generally hard to get out of.
- Borrow only the amount necessary to meet a specific need. If you borrow the maximum of your home’s equity without a plan, you may spend the extra money unwisely.
- If a new mortgage loan is secured via the cash-out refinancing option and the term of years for the loan to be repaid is extended, you are prolonging the amount of time and increasing the amount of interest necessary to pay off the loan. This may postpone or eliminate achieving your other goals.
Tapping home equity can be a viable and beneficial financial strategy for many reasons but also comes with its fair share of risks. Consider getting advice from a CFP® professional if you are interested in accessing the equity in your home.
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