For many homeowners, the last few years have been a gold rush.
Homeowners gained more than $14,300, on average, in their home equity between the fourth quarters of 2021 and 2022. That’s a slower increase in home equity gains compared with the $63,100 gain in the first quarter of 2022.
Overall, $1 trillion was added in total U.S. home equity during the same period, representing a 7.3% jump year-over-year, according to CoreLogic, a real estate data analytics company.
Although there’s been a notable cooling in home-price appreciation recently, many homeowners remain flush with equity. However, the equity remains locked in their house until the owner sells the home or taps their equity through a cash-out refinance, a home equity line of credit (HELOC) or a home equity loan.
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How To Use Equity in Your Home
The most popular ways to access your home equity without selling the home are: Cash-out refinance, a HELOC or a home equity loan. All three work in different ways and have a different time period for when you receive the funding.
Keep in mind, these are financial products that help you tap your home equity for many needs—like remodeling your home or paying for a child’s college costs. However, you’ll still have to pay it back over time or via a lump sum if you sell your home.
How a Cash-out Refinance Works
Cash-out refinancing allows you to access your home equity through a first mortgage instead of a second mortgage, like a home equity loan or line of credit. It essentially replaces your current mortgage.
Generally, you’ll need to have 20% equity left in the home after refinancing; however, some lenders will let you dip below that 20% equity minimum, but you may have to pay for private mortgage insurance (PMI) on the new loan if you do.
Cash-out refinances replace your existing mortgage, so the terms will change. You can shorten or lengthen the amount of time you have to repay your new mortgage. Be sure to factor in closing costs, which can range from 2% to 5% of the new loan amount.
How a HELOC Works
HELOCs function more like a credit card, where the lender extends a line of credit for an amount based on the equity in your home. Then you can access those funds as needed, instead of getting a lump-sum payment. Borrowers can use what they need and once they pay off the balance, the loan is over.
How much credit you get largely depends on how much equity you have in your home. Lenders usually require homeowners to retain at least a 20% equity in their home. There are some lenders who only require 15% equity and others, like Navy Federal Credit Union, who allow borrowers to take out 100% of their home equity.
HELOCs are paid back in two phases:
- Draw period: This is the timeframe that borrowers have to access their credit, usually 10 years. During this time, the HELOC typically has an adjustable-rate (can adjust every six weeks) and borrowers are only required to pay the interest each month. However, you can also choose to pay on both the interest and principal.
- Repayment period: Once that draw period is over, you can’t touch any more credit and you must repay what you have borrowed, so your payments will get higher. Budgeting and planning for the repayment phase ahead of time is key to get a better handle on higher bills.
Generally, borrowers have 20 years to repay their HELOC and the interest rate usually switches from an adjustable-rate to a fixed-rate structure once you enter the repayment phase.
How a Home Equity Loan Works
A home equity loan is a second mortgage that allows you to borrow against your home equity and receive funding in a lump sum. Like most loans that allow you to tap your equity, borrowers will generally be required to keep at least 20% equity in their home.
These loans tend to be a fixed-rate loan. Unlike a cash-out refinance, home equity loans don’t replace your mortgage, which is beneficial for people who have a low interest rate and don’t want to change it by refinancing.
Typically, borrowers have 20 years to repay their home equity loan, but some lenders offer terms of up to 30 years.
Cash-out Refinance vs. HELOC vs. Home Equity Loan
Cash-out refinances are attractive for borrowers seeking to lower their interest rate while also taking cash out of their home. However, interest rates are rising to the highest levels in more than a decade so there will be fewer borrowers who can refinance into a rate lower than the one they currently have.
Related: Compare Current Mortgage Rates
Refinancing can also be expensive—costing anywhere between 2% to 3% of the refinance value in closing fees, so replacing a low-rate mortgage with a costly higher-rate mortgage might not be the best financial decision.
Unlike refinancing, HELOCs don’t affect your mortgage. So you can keep your low-interest rate and still get cash from your home.
HELOC’s also tend to have lower closing costs than cash-out refinances, and the interest rates on a HELOC are lower than average credit card rates.
“For the last several years cash-out refinancing had muted a great deal of HELOC activity,” says Steve Kaminski, head of U.S. residential lending at TD Bank. “Now that current mortgage rates are rising, homeowners who previously locked in at those low, fixed rates (and now need financing for renovation work or other large purchases) are taking advantage of the current lower cost HELOCs.”
However, the interest rate for HELOCs is also increasing. The starting interest rate on a 20-year HELOC is 5.14% as of April 6. That’s considerably lower than the average interest rates on credit cards, ranging between 16% and 24% depending on your creditworthiness. When you’re ready to shop around, check a rate table for the most
Related: Current HELOC Rates
“Repayments can be situational and right now can be very unique. The variable rates float with the market as it changes and it experiences highs and lows,” says Steven Ostad, founder and principal of Real Quick Capital, a private real estate lender. “Like all loans, it’s best to pay them down as quickly as possible if you have the opportunity to, but with HELOCs it’s ever more pertinent given the collateral on the line.”
Repayment strategies are key when deciding between a HELOC and a home equity loan. The HELOC can be beneficial for people who don’t necessarily need a big lump sum, but want cash available when they need it. Some people choose to open a HELOC in case of emergencies and never actually use any of the credit.
A home equity loan, on the other hand, commits you to a large amount of cash–which is fine if you need it, especially since the payments are fixed over 20 years or more.
Should You Tap Your Home Equity?
Although it can be tempting to pull out tens of thousands of dollars from your home, before you make the leap, it’s a good idea to answer a few simple questions:
- What are you going to do with the money? Paying off high-interest loans or investing the money back into your house via upgrades or repairs can be a fruitful way to spend equity. For example, if you need a large amount of cash but don’t want to change your first mortgage, a home equity loan might be a more attractive option. On the flip side, borrowing against your home for unnecessary expenses or vacations are usually not advisable as you’re racking up debt using your home as the collateral.
- What sort of payment schedule works better for your budget? If you prefer the same equal monthly payments at a fixed rate, then a cash-out refinance or a home equity loan might be better. Conversely, HELOCs are like credit cards, they can be great to have in a pinch or if you’re uncertain how much money you’ll need.
- How do you plan to repay your debt? On the other hand, if you tap all your HELOC funding and only pay the interest during the draw period, which can last a decade, you could end up with a huge amount of debt later on. If you don’t have a solid plan to cover that debt, foreclosure could be inevitable.
“As the prime rate increases, your payment will increase with it, making it critically important to factor in potential payment increases as you consider your options,” Kaminski says. “Speaking with a qualified lender about your credit history, financial budget, and goals in advance of applying is an important step to mitigating this risk.”
How To Tap Into Home Equity With Bad Credit
Getting a home equity loan with bad credit is possible. Here’s how to do it:
- Improve your chances of loan approval. You can do this by paying off debt or increasing your income to lower your debt-to-income (DTI) ratio, boosting your credit score, ensuring you have sufficient equity in your home and getting a co-signer with a strong credit history.
- Find lenders willing to work with bad credit. Shop around and get quotes from several mortgage lenders. Community banks and credit unions might have more flexibility when it comes to their underwriting standards, especially if you are already a customer. Online lenders might also be more willing to take on riskier loans.
How To Build Home Equity
You can build home equity in two ways:
- The home’s market value, or the price you could sell it for, goes up
- Paying down your mortgage principal, which in turn increases your equity—so long as your property’s value is stable or increasing
The longer you’ve had your mortgage, the faster you build equity with each monthly payment.
Frequently Asked Questions (FAQs)
What can I use a home equity loan for?
You can use a home equity loan for any purpose that requires a large amount of cash upfront, such as a home renovation or paying off a medical bill. Just note that if you use the equity you withdraw for any purpose other than to “buy, build or substantially improve your home,” you won’t be able to deduct the mortgage interest on that amount, according to the IRS.
Can you take equity out of your house without refinancing?
Yes. You can get a HELOC, a home equity loan or enter into a sale-leaseback agreement where you sell your home to another party in exchange for 100% of your equity. Then, you rent the property back from the buyer at market value.
When to take equity out of your youse?
The decision to take equity out of your home relies on a number of factors. For example, when mortgage rates are low, it may make more sense to do a cash-out refinance or get an affordable home equity loan.
Also, tapping home equity is tax free because it’s in the form of a loan. On the other hand, you’ll pay capital gains taxes if you sell your home. Finally, if you need a large amount of cash on hand, then taking equity out of your home may be a good option.
Is a cash-out refinance or home equity loan better?
If you’re deciding between a home equity loan and a cash-out refinance, the right choice depends on your specific needs and timeline. Both options give you access to the cash you need fairly quickly; however, a home equity loan comes with a higher interest rate.
On the other hand, if your existing mortgage has a low interest rate, it may not make sense to do a cash-out refinance in this environment as costs may be higher on your new loan. Also, cash-out refinancing makes financial sense only if you plan to live in your home long enough to reach the loan’s break-even point.
The break-even point is the amount of time when your monthly interest savings surpass your total closing costs. Divide your closing costs by the monthly savings from your new mortgage payment to get the number of months you’ll need to stay in your home in order to break even on the cash-out refinance.
