What to do with home equity

person holding pencil near laptop computer

How most homeowners use their home equity

Home equity is a sure source of cash that homeowners can tap into for any number of reasons. That’s why your home equity is a convenient way of accessing the lump sum you need for home improvements or to consolidate debt.

There are plenty of upsides to using home equity but you want to make sure you can pay it back on time since your house is the collateral.

Depending on what project or life expense you want to pay for, you’ll take out a home equity loan, a home equity line of credit (HELOC), or a cash-out refinance. Talk to Flyhomes Mortgage for more information about your home value and what’s possible with your equity.

Key takeaways:

  • Home equity is the difference between what you owe on your mortgage and what your home is currently worth
  • Home equity builds as you make regular mortgage payments or the value of your home goes up
  • Tapping into home equity helps you pay for large life expenses using your home as collateral
  • Home equity loans usually have a lower interest rate than personal loans
  • You can access home equity through a home equity line of credit (HELOC), a home equity loan, or a cash-out refinance
  • The best way to tap into your home equity depends on the kind of expense you plan on using it for
  • Most people use equity to consolidate debt, for home improvement projects, emergency expenses, business loans, college tuition, and weddings

What is home equity?

Home equity represents your stake in the property. It’s the portion of your home that is “yours” as opposed to the lender’s and is based on how much you’ve paid off and how much your home is worth. Calculate it by taking the appraised value of your home and subtracting any outstanding mortgage and loan balances.

Home equity builds over time as you make regular mortgage payments and as your home’s value goes up. Home equity is especially important if you decide to sell your home. The profit you stand to gain by selling your home is your equity minus closing costs and fees.

Why use home equity?

Tapping into home equity is beneficial for homeowners who need a predictable and inexpensive way of accessing a large sum of money. Two key benefits of using home equity as opposed to other forms of financing are:

  • Lower interest rates

Personal loans are usually unsecured and come with high-interest rates. But your home is not unsecured—it’s backed by a mortgage. So most lenders view home equity loans as less risky and offer lower interest rates than on other loans.

  • Tax benefits

According to the 2017 Tax Cuts and Jobs Act, homeowners can deduct interest on home equity loans or lines of credit up to $750,000 they use the money to “buy, build, or substantially improve” the home that secures the loans.

How does home equity work?

Financial institutions like banks, online lenders, and credit unions all offer home equity loan products. You can apply for them just like to how you first got your mortgage.

Lenders consider multiple financial factors when providing home equity loans and lines of credit. Here are the most common financial criteria of a home equity loan:

  • credit score of 650
  • debt-to-income ratio below 43%
  • 20% stake in the property

Your stake in the property is another way of saying the amount of equity you have in the property. To have 20% equity in the property, the debt you have left to pay off needs to be no more than 80% of the current value. Whichever lender you choose for your home equity loan will send an appraiser to determine the current value. Then they’ll use that information to determine how much equity you have available. 

It’s important to keep in mind that lenders will only allow you to borrow a percentage of your home’s equity. The exact percentage depends on the lender, but the maximum loan-to-value ratio is around 80-85% of the property’s appraised value.

a person writing on notebook using a pencil
Home equity is a tried and true method of getting cash to pay for big expenses, but make sure you can actually pay it back on time or you could lose your home

Home equity products

Home Equity Line of Credit (HELOC)

With a home equity line of credit you can borrow however much you need within the designated loan amount and pay back what you use—with interest. HELOCs are the most flexible home equity products because you borrow only what you need as you need it. This is different from home equity loans which come as one lump sum.

Equity lines of credit work in the same way as a credit card, but with lower interest rates. Your monthly payment is based on the amount of credit used as opposed to the total loan amount. A HELOC has two phases:

  • Draw period: The draw period lasts anywhere between 5-10 years. During this time, borrowers can withdraw up to their line of credit and make interest-only payments.
  • Repayment period: The repayment period comes immediately after and lasts 10-20 years. This is when the total amount you’ve borrowed becomes a loan to be repaid. During this time you can no longer make any withdrawals.

Home Equity Loan

A home equity loan functions as a second mortgage which you repay over a period of time. A home equity loan usually has a higher interest rate than your first mortgage because it adds financial risk to the mortgage you already have. It is a good option for if you can begin paying down your loan immediately with fixed payments.

Cash-out Refinance

When you use a cash-out refinance, you’ll take out a loan for the new, higher value of your home, then use it to pay off the original mortgage and keep what’s leftover. It doesn’t involve a second loan, but it does come with closing costs. This is because you’ll end up with less equity in your home than you had before. Basically, your equity will start over. This is usually the most convenient option for borrowers who need a lot of cash for an upcoming expense.

Reasons to tap into home equity

white wooden cupboards
A lot of homeowners pay for things like kitchen remodels with a home equity loan because it helps the value of their home go up

You can use your home equity loan for just about whatever you want. But there are some things that make more financial sense to pay for with your home equity.

Home improvements

Home improvements are some of the most popular reasons people use their home equity. In addition to making your home more comfortable and aesthetically pleasing, renovations like a remodel can increase the value of your home.

As previously mentioned, there’s an added tax benefit to using a home equity product for your home renovation(s). Tapping into home equity for a large home improvement project, or a series of smaller ones, usually ends up paying for itself in the long run.

Emergency expenses

A lot of financial experts will tell you that it’s best to have a savings account to cover at least 6 months of expenses but only 23% of Americans actually do. In the event of an emergency, tapping into home equity may be the best, and only, way to stay afloat.

Keep in mind that you’ll need to go through somewhat of a lengthy application process, so if your emergency is time-sensitive, then you may want to consider other options.

Small business growth

Some homeowners use home equity to fund their small businesses. If you’re a business owner and need capital to grow, a home equity loan can be less expensive and more financially viable. But running a small business is always a risk and you shouldn’t expect to make a profit on it right away.

Debt consolidation

Another common reason to take out a home equity loan or HELOC is to consolidate high-interest debt at a lower rate. If you happen to have a large amount of unsecured debt with high-interest rates like car loans, student loans, or credit card debt, it may be best to consolidate these debts into a single, low-rate loan.

College costs

Lenders don’t always let you use home equity for education, but the practice has gotten more popular as college tuition goes up. The use of home equity can be particularly beneficial because mortgage rates are lower than student loan interest rates, even as mortgage rates go up.

Wedding expenses

Many financial experts will advise against going into debt for a wedding, but the truth is, many couples do it anyway. It’s a special day that happens only once in the lives of many Americans, so they’re willing to spend a considerable amount on their big day.

The average cost of a wedding in 2020 was $19,000. This is why couples turn to wedding loans with high-interest rates to fund their weddings. A home equity loan or HELOC provides the cash they need to pay for their wedding expenses at a lower interest rate.

What to know about using your home equity

Now that you know what home equity is and how it works, it’s up to you to decide if tapping into your home’s equity is necessary. You can use equity for a number of different ways. But make sure you’re pulling your equity out of your home for a worthy cost you’re confident you can pay back.

The first thing you want to keep in mind is that there is a limit on how much you can borrow. Depending on what you plan on using your home equity for, the loan or line of credit you get approved for may not be enough to cover your expense in full.

There’s also no guarantee that your home will increase in value overtime. If you happen to take equity out of your home and the value of your home declines due to storm damage, a fire, or a drop in real estate value, you could end up owing more on your mortgage than what your home is worth. This is also referred to as being underwater on your mortgage.

Lastly, it’s worth reiterating that it is not always necessary to tap into your home’s equity. It’s a highly valuable asset that you want to reserve for when it is absolutely necessary. If there is another financially sound way to fund your wedding expenses or small business, then you should consider taking that route before tapping into your home’s equity.

About the author: Vivian Tejada is a freelance writer and small business strategist based out of Providence, RI. She specializes in writing SEO blogs, property descriptions and website content for real estate companies. She’s also an avid traveler, location-independent and enjoys trying out new restaurants.

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