Home equity is the part of your home’s value that you already paid for. You can calculate it by subtracting how much mortgage you still owe from your property’s appraised value or fair market value. For example, if your home is valued at $350,000 and you have a remaining mortgage balance of $150,000, your home equity would be $200,000.
An important thing to remember is that your home equity can fluctuate depending on changes in your home’s value or if you make extra payments on your mortgage. If you are looking to tap into your home equity, you should know a few things to do so successfully.
1. Consider the pros and cons
There are three main ways that homeowners access their home equity. Each option has its own pros and cons that need to be considered before making a decision.
a. Home Equity Loan
A home equity loan is a one-time, fixed-interest-rate, lump-sum financial assistance that you take out to pay off your mortgage. Because it is a fixed-rate loan, a home equity loan gives borrowers certainty about their monthly payments. This can be helpful if borrowers use their loan proceeds for a one-time project with predictable costs like renovation projects or consolidating debt.
On the downside, borrowers who take out a home equity loan may pay more interest over time than they would with a HELOC because they are borrowing all of the funds at once.
b. Home Equity Line of Credit (HELOC)
This option is similar to a credit card in that it provides borrowers with a line of credit they can draw on up to a certain limit as needed. HELOCs are unique because they are secured by your home—meaning that if borrowers fail to make payments, their lender could foreclose on their property. HELOCs usually have variable interest rates, meaning borrowers’ monthly payments could increase if rates go up. However, because borrowers only need to pay interest on the portion of the line of credit they tap into, they could pay less interest overall than with a home equity loan.
c. Cash-out Refinancing
Compared to taking out a home equity loan or HELOC, refinancing involves taking out a new first mortgage that pays off your existing one and provides you with additional cash. How much cash you can get depends on your home’s equity, your home, the current market value of your home, and your creditworthiness.
This can be a good option for borrowers who want to lower their interest rate or change the terms of their mortgage. However, it also means taking on a new 30-year mortgage, which could increase the amount of interest you pay over time.
2. Determine why you want to access your home equity
Before deciding to access your home equity, it’s essential to ask yourself why you want to do so. Are you looking to make improvements to your property? Consolidate debt? Or pay for a large purchase? Once you know how you will use the funds, it will be easier to determine which option is best for you.
A good rule of thumb is to only access the equity in your home if you are confident you will be able to repay the loan. If not, you could risk losing your home. If you are unsure whether you will be able to repay the loan, it may be best to speak with a financial advisor before moving forward. They can help you create a budget and payment plan that work for your unique financial situation.
3. Figure out how much equity is available to you
Your lender will typically allow you to borrow up against 80% of the value of your home (minus any outstanding mortgage balance). So, if your home is valued at $250,000 and you have a remaining balance of $150,000, then most lenders would allow you to borrow up to $80,000 through a home equity loan or line of credit. The more equity you have available, the more options may be open to you.
This rule is basically a requirement to maintain a minimum amount of equity in your home. Lenders do it to protect themselves in case your home’s value decreases, and you cannot sell it for the amount you owe. But it also protects you, as the homeowner, by ensuring you have some skin in the game. This way, if you default on your loan and the lender has to foreclose, they will at least recoup some of their losses.
Tapping into your home equity can be a great way to finance major expenses or consolidate debt. However, it’s essential to do your research and understand all of the risks involved before taking out a loan. With careful planning, tapping into your home equity can be a great financial move for you and your family.