Homeowners have gained a lot of equity over the past few years. According to real estate data analyst CoreLogic, total homeownership will increase by $1.5 trillion in the first quarter of 2024, up about 10% from the same period last year. If you’re looking to borrow money, tapping into your home equity can be less costly than credit cards or other financing methods. Here are the basics of tapping into your home equity and how to do it.
What is home equity?
Home equity is the difference between the appraised value of your home and the remaining balance on your mortgage.
When you buy a home, you have some equity right away — this is the equivalent of your down payment, or any money you put down up front rather than financing — and then over time, your mortgage payments build more equity and your home increases in value due to market conditions and/or home upgrades.
$305,000
Average home equity held per average mortgage-holding homeowner in the U.S. in 1Q24.
Source: CoreLogic
How to Calculate the Equity Value of Your Home
You can calculate your home equity by taking the appraised value of your property and subtracting the balance of your mortgage. For example, if your home is appraised at $200,000 and your loan balance is $120,000, your home equity is $80,000.
Lenders have a maximum amount you can borrow against your home’s equity, often set at 80 percent or 85 percent, and they’ll also evaluate your loan-to-value ratio (LTV), or the amount of your mortgage remaining against the value of your home.
LTV ratio calculation
To calculate your loan-to-value ratio (LTV), divide the amount of your existing mortgage by the appraised value of your home. Using the example above, your LTV would be 60% if you divided your mortgage balance ($120,000) by your home’s appraised value ($200,000). A 60% LTV ratio means that you have 40% equity in your home.
How to unlock the value of your home
There are three common ways to convert shares into cash.
Mortgage
A home equity loan is a fixed amount, fixed interest rate loan that you repay over a set period of time (usually 20 years). It works similarly to a mortgage in that the loan is secured by the equity of your home.
A home-equity loan is a second mortgage that usually carries a higher interest rate than a first mortgage. (As of Aug. 21, the average interest rate for a benchmark $30,000 loan was 8.52 percent, compared with 6.52 percent for a 30-year fixed-rate mortgage, according to Bankrate’s national lender survey.) The difference comes down to the lender’s ranking of creditors: if you default on your loan and your home is foreclosed, the home-equity lender can claim the proceeds from the sale of the home, but only after the first mortgage lender has recouped its money.
Strong Points
- Great for those who own most of their home outright
- It’s perfect if you need a lump sum of money for a big home improvement project or to pay off credit card debt.
Cons
- Not suitable for people who already have large mortgages as collateral
- It’s not ideal if you only need the money for non-essential discretionary expenses.
When it makes sense
To cover a single home improvement project or other large expense, or to pay off a high-interest credit card.
Mortgage-backed securities
A home equity line of credit (HELOC) has a revolving balance like a credit card, which means you’re approved for a certain amount of loan, but you don’t have to borrow the full amount. You can borrow as much as you need. HELOC interest rates fluctuate with the prime rate, but some lenders allow you to convert a portion of your HELOC balance to a fixed interest rate.
A HELOC typically involves a two-stage loan over 30 years. The first 10 years are the draw period, during which the line of credit is open and you usually only pay interest. Once the draw period ends, you no longer have access to the funds. After that, you have 20 years to pay off both the principal and interest.
Strong Points
- Great if you want the freedom to withdraw funds when needed
- Good for long-term obligations or when you’re not sure exactly how much you’ll need
Cons
- Not ideal if you don’t want variable interest rates or fluctuating payments
- Not ideal for people who don’t want to be in debt for a long time
When it makes sense
To fund a long-term, multifaceted home improvement project, to cover the costs of continuing higher education, or to fund a new business venture.
Cash-out refinancing
With a cash-out refinance, you refinance your current mortgage for at least the amount of your outstanding balance and receive the difference in cash. Because a cash-out refinance replaces your existing mortgage, you may be able to get a lower interest rate or better terms on your new loan, depending on market conditions.
Strong Points
- Either way, it’s a good thing if you’re considering refinancing your mortgage.
- Good choice if you prefer one loan over two
Cons
- Not ideal if you don’t have a lot of equity in your home
- Not ideal if you can’t get a lower interest rate than you currently have
When it makes sense
You can borrow at an interest rate that is the same as or lower than your current mortgage, and you need cash all at once for a large expense.
How to Choose the Best Home Investment Solution for You
The best home equity option for you depends largely on what you plan to do with the money. Consider the following scenarios:
- Debt repayment: To pay off high-interest debt, like credit cards and other loans, a mortgage may be the way to go. That way, you can borrow only the amount you need to pay off your outstanding balance. Plus, a fixed interest rate locks in your monthly payments, making it easier to budget.
- University Tuition Fees: A HELOC may be a better option for tuition and other higher education expenses: You know those bills will come up periodically for at least a few years, so it makes more sense to withdraw funds as needed, especially since you only accrue interest on the amount you actually borrow.
- Home renovation: The best option for this scenario depends on what your project is and whether you know exactly how much you need. If it’s a single item or project, like replacing an HVAC system or installing a pool, consider a mortgage or cash-out refinance. But if you’re tackling a multi-phase remodel, like an addition, with ongoing costs and an open-ended deadline, a HELOC might be a better choice. That way, you can pay contractors in installments and have a reserve fund you can draw on if the project goes over budget.
How much equity can you withdraw from your home?
Essentially, it depends on how much equity you have and the lender’s criteria for borrowers. Lenders will analyze:
- Home Value
- Credit score
- Credit History
- Income Level/Wealth
- DTI ratio/debt, especially other home equity loans
Regardless of your creditworthiness, you won’t have access to all of your equity. On paper, your equity may be worth, say, $100,000, but your actual available equity — the amount you can actually use — will be significantly less. Most lenders will let you borrow up to 80 to 85 percent of the home’s appraised value, even if you own the whole house outright. If you have $100,000 equity, you can’t borrow $100,000. In other words, your maximum amount is $80,000 to $85,000. Some lenders will let you borrow up to $90,000.
Read more: How much equity can you borrow against your home?
The benefits of unlocking the value of your home
When you need to cover a big expense, like home improvements or college tuition, tapping into your home equity can help you get the financing more cheaply.
- Low interest rates: One of the main benefits of tapping into your home equity is that you can often access cash at a much lower interest rate than a personal loan or credit card. “Home equity is often the least expensive form of financing for homeowners,” says Vikram Gupta, executive vice president and head of home equity at PNC Bank. “Because the loan is secured by your home, lenders can lend at lower interest rates compared to other consumer lending products.”
- Increased flexibility: HELOCs and home equity loans have few restrictions and allow you to use the funds however you like.
- Potential tax benefits: If you use funds from a mortgage or line of credit to pay for home improvements, the interest you pay may be tax deductible. According to the IRS, the deduction is generally allowed if you use the funds to “purchase, build, or substantially renovate a home.” You also have to itemize the deductions on your tax return.
The risks of unlocking the equity in your home
Although unlocking the equity in your home has its benefits, it is not without risks.
- Your home is collateral: The biggest downside to taking out a home equity loan (HELOC) is that your home is used to back the debt, “which means you run the risk of the lender foreclosing (seizing) your home if you can’t make the monthly payments over an extended period of time,” says Gupta.
- Possible impacts on credit and borrowing: If your home is foreclosed on, your credit score can drop significantly. A foreclosure will remain on your credit report for seven years from the date of your first missed mortgage payment. After that, lenders may not allow you to borrow for several years. Borrowers usually have to go through a waiting period before they can qualify for a mortgage. You may also get a deficiency judgment, which is a court order that allows lenders to collect additional money from you. Lenders can garnish your wages, put liens on other assets you own, or seize your bank accounts.
- Market downturn: Another concern that often comes with giving up equity in a home is the possibility of a decline in property values or an overall downturn in the real estate market. “If home values are declining in a particular market, borrowers run the risk of owing more than the home is worth,” says Jason Salcido, assistant vice president at PenFed Credit Union.
Other considerations when taking out a mortgage
If you think you’re ready to leverage your home equity, here are some things to keep in mind.
- Home values are relatively low: Interest rates on HELOCs and home equity loans are often much lower than those on credit cards and other types of loans, and they can be easier to qualify for. This is because a home equity loan is a secured loan, which means it’s backed by collateral (in this case, your home).
- Home prices are likely to fall: One reason to be careful with mortgages is because home prices fluctuate. If you take out a big loan and home prices fall, you’ll end up owing more than your home is worth. This is called “upside-down” or “underwater.” The 2008 housing bubble burst led to falling home prices and millions of borrowers were trapped in homes they couldn’t sell as their mortgage debt exceeded their home’s value.
- Your home is at risk: If you bought or refinanced your home when interest rates were low, you need to ask yourself how wise it is to do a cash-out refinance, especially if the interest rate you’re borrowing at is significantly higher than the interest rate on your existing mortgage. If you fall behind on your payments, you risk foreclosure.
Next steps
If you’re considering borrowing against the equity in your home, the next step is to estimate how much your home is worth. Then, divide your existing mortgage balance by the value of your home to calculate whether you qualify for a mortgage or refinance.
Next, make a plan for why you want to unlock the equity in your home and how and when you’ll pay it off. It’s best to have a specific goal that will benefit you financially. This could be anything from consolidating other debt at a lower interest rate to increasing the value of your home through a major home improvement project.
Finally, whether you choose a HELOC, a home equity loan, or a cash-out refinance, shop around to understand your options. Bankrate’s home equity lender reviews can help you compare.
