Inflation and the rising cost of living have you feeling the need for extra cash — as we all feel these days — and you’ve realized a valuable source of funds might be right in your own home.
Older homes are worth record amounts of equity, thanks to rising fair market values, faithful mortgage payments, and equity buildup. (In fact, according to real estate data analytics firm ATTOM, nearly half of all mortgaged U.S. homes are “highly equity,” meaning the owner’s mortgage balance is less than half the home’s value.) So you might be tempted to take advantage of equity through a home equity loan, HELOC, or cash-out refinance.
But the truth is, even if you intend to put the funds to good use, borrowing against your home equity may not be a good idea. The reasons range from the timely (relatively high interest rate environment) to the permanent (the risk of pawning your home for cash), to the current economic situation (a shaky real estate market) to your personal finances (the risk of getting overindebted). (We won’t get into questionable uses here, like buying a new car or booking a two-week cruise.)
In fact, a recent Bankrate survey found that 18% of current U.S. homeowners say they have no reason at all to liquidate their home equity.
Here’s what to consider when deciding whether to borrow against the value of your home and why you should or shouldn’t do so.
What is home equity?
Home equity, simply put, is the amount or percentage of your equity that you have paid off, i.e. that you own outright. It is the difference between the appraised value/current market value of your home and your outstanding mortgage balance. In other words, this is the amount of money you have left over when you sell your home after paying off the debt you owe to your lender (not including closing costs).
According to the Federal Reserve, American homeowners will collectively hold more than $32 trillion in home equity as of the first quarter of 2024. Homeowners who hold a mortgage have an average individual equity of about $300,000. Because lenders typically allow you to borrow against about 80% of your equity, this equates to a maximum of $240,000 worth of available funds, or “available equity,” as financial professionals call it.
Nearly two-thirds of this available equity is held by homeowners with credit scores above 760. High scores are important to lenders because these homeowners are more likely to repay their loans, making them lower-risk borrowers.
How do you leverage your home equity?
Before we dive into the pros and cons, let’s quickly review the basics: There are three main ways to tap into the equity you’ve built up: a cash-out refinance of your mortgage, a home equity line of credit (HELOC), or a home equity loan.
Cash-out refinancing
With a cash-out refinance (or refinance for short), you replace your existing mortgage with a new, larger mortgage. The difference between the amounts of the two loans is the cash you have on hand at closing, which represents some of the equity you’ve built up in your property (lenders may require you to hold at least 20 percent of the equity in your home). The outstanding principal of the new loan will be higher than the principal of the loan you’re replacing, but it can be for a shorter or longer term.
“For example, if you owe $100,000 on a home worth $200,000, you could take out a new mortgage for $150,000 and receive the remaining $50,000 in equity in cash,” says Rick Sharga, president and CEO of CJ Patrick, a business consulting firm based in Irvine, Calif. “But it’s important to realize that in this example, this increases your debt from $100,000 to $150,000, and you’ll generally end up paying more interest over time.”
As with most refinancings, you’ll also have to pay closing costs.
HELOC (Home Equity Loan)
A HELOC works as a revolving line of credit with a variable interest rate. It’s similar to using a credit card, but instead of the debt being unsecured (as with plastic cards), you have to provide your home as collateral. Like a credit card, you can borrow whenever you need to (within a limited drawdown period), pay back the amount you borrowed, and borrow again if needed.
With a HELOC, your credit limit is based on your available home equity. Typically, you can borrow up to 80 to 85 percent of your home’s value (not including any outstanding mortgage balances). During the draw period (usually the first 10 years), you’ll pay interest every month on the amount you borrowed, but your funds are replenished as you pay down the principal. You won’t have access to the funds during the repayment period, and you’ll be obligated to pay back the principal and interest over an average of 10 to 20 years.
“It’s one of the most common ways homeowners access their equity,” says Seth Bellas, mortgage expert at Churchill Mortgage. “Many people use a HELOC to make a big purchase, renovate their home, or consolidate debt. It’s usually more affordable than a cash-out refinance, and the interest rates and limits are much more attractive than a personal loan or credit card.”
HELOCs have variable interest rates that change (often from month to month) as the prime rate fluctuates, so your overall balance and monthly payment will also fluctuate.
Mortgage
A home equity loan is a type of second mortgage that is secured by the equity in your home. Like a HELOC, your home is used as collateral for your debt (meaning you can lose your home if you don’t repay the loan). Unlike a HELOC, the amount you borrow is fixed and is paid in a lump sum at closing.
“Using the previous homeowner example (who owes $100,000 on a home worth $200,000), they could borrow $50,000 against the equity in their home and begin making monthly payments on the second loan in addition to their monthly payments on their main mortgage,” Sharga says. Terms vary, but a home equity loan can be paid off over up to 30 years.
“Homeowners with very good current mortgage rates may consider this option over a cash-out refinance, which can have higher interest rates,” Sharga continues. Lenders often offer lower interest rates on home equity loans compared to personal loan or credit card rates. “However, second mortgages tend to have higher interest rates than primary mortgages, so borrowers should consider this before using this option,” he adds.
$1.5 trillion
Total U.S. mortgage holders’ total assets will increase 9.6% year-over-year in the first quarter of 2024
Source: CoreLogic
Reasons for not using home equity
Just because you can leverage your home equity in one of the ways above doesn’t mean you should — even if you intend to spend the money wisely, such as putting it towards home improvements to increase the resale value of your property. Some of the reasons have to do with the current economic climate, and some are more universal and personal when it comes to personal finance.
Interest rates remain relatively high
Consider the reasons for the delay: It’s more expensive to borrow money now than it was a few years ago. At the start of 2022, interest rates on home equity loans ranged from 4% to 6%; by August 2024, they’re at 8.45% to 11.14%. “Homeowners are having to face a new reality: home equity is no longer a low-cost form of debt,” says Greg McBride, chief financial analyst at Bankrate.
On the positive side, interest rates on home equity loans and mortgages have fallen recently and are expected to fall further in 2024. The Federal Reserve is expected to lower its key interest rates at its next meeting in September. When that happens, interest rates on new home equity loans and HELOCs typically fall as well. These are tied to the prime rate, which tends to move in tandem with Federal Reserve decisions.
“The pattern of easing from the Fed, which is expected to cut interest rates over the coming months, should lead to lower borrowing costs,” said Mark Hamrick, senior economic analyst and Washington bureau chief at Bankrate.
You may end up in a lot of debt
Another reason to put off writing down your home’s equity is that your total debt could pile up, making it difficult to repay your outstanding balance over the coming months and years. “Writing down your equity will increase your total debt and the amount you owe to your lender (both principal and interest) over time, so it’s important to weigh the short-term benefits against the long-term costs,” Sharga points out.
HELOCs in particular can be a trap. “Many homeowners find it difficult to keep up with payments on their lines of credit,” says Bellas. During the initial drawdown period, “most HELOCs only require you to make monthly interest payments, similar to how a credit card has a minimum payment. By the time the full repayment is due, you’ve not only paid back the principal, but also the interest on that principal, which can get pretty tough if you’re not in good financial shape.”
Your financial situation could also worsen through no fault of your own. The current economic environment remains highly uncertain, Hamrick notes. If the economy slows or a negative event occurs in the coming months, job losses and income disruptions could create hardship for many individuals and households. “Given the prevalence of high interest rates, taking on more debt may not be the best decision for some,” he says.
The housing market and home prices are unpredictable
If you’ve been following the residential real estate market closely in 2023, you know that sales and asking prices have fluctuated in different parts of the country. As we enter 2024, home price increases have hit record highs, while home affordability and availability have never been worse.
“Home affordability may improve slightly, but remains constrained given the lack of homes for sale,” Hamrick said. “If mortgage rates continue to fall over the next year or so, the so-called lock-in effect could reverse, allowing more homes to enter the market. The performance of the overall economy is also key. A significant increase in unemployment would be detrimental to the housing market.”
While the national economy plays a role, real estate is highly localized. While rising across the U.S. in the first quarter of 2024, the average increase in home equity varies widely by state, ranging from $63,800 per homeowner in California to $600 in Texas. The risk of losing equity is especially high if local market values are falling, Sharga stresses. “You may end up owing more on your home than it’s worth,” he says.
While it’s rare to end up in a negative equity situation like this, it could happen if local real estate prices fall sharply over an extended period of time and you have a lot of debt.
You are putting your home at risk
With a mortgage product, the debt you incur is secured (i.e., backed by something): your home. And because of that, the risk is greater if you miss a payment. Missing or being late on other debts is unpleasant and will have a negative impact on your credit report and score, but that’s it. Here, on the other hand, you’re mortgaging against what is probably the largest asset you own: your real estate.
That’s why you need to think especially carefully about why you need money. It may be tempting to spend the equity in your home on a vacation or a fancy new car, but it carries big risks for a temporary reward. Vacations create memories but not much else. Cars depreciate the moment they leave the dealership.
While other uses may be more beneficial, consider alternatives first: College tuition, for example, can often be covered through financial aid or more competitive financing options (such as federal student loans).
Bankrate Tips
Bankrate’s Home Equity Insights survey found that 16% of homeowners consider tuition and education costs and investments good enough reasons to use their home equity, while only 7% would use their home equity for vacations and only 6% think it’s worth using their home equity to buy big-ticket consumer items.
Shalga recommends asking yourself: Is it worth the possibility of losing your home to foreclosure if market conditions or your personal financial situation worsens?
Also consider that when you sell your equity, your rights in the homeownership are diluted, thus reducing the value of your property and your overall net worth.
Leveraging your equity increases your total debt over time and increases both principal and interest owed to lenders, so it’s important to weigh the short-term benefits against the long-term costs.
— Rick Sharga, CEO of CJ Patrick Company
Tips for leveraging your home equity
If you’re serious about turning some of your home’s equity into cash, here are some tips.
- Substantial conflict of interest: Hamrick says the people who can best leverage home equity are those who have built up a significant amount of equity — meaning their home is worth much more than the balance of their mortgage. “This typically includes people who have lived in their homes for a long time and haven’t refinanced frequently. They should also have a high degree of confidence in their job and income stability,” he adds. “New homeowners should wait until their home equity is higher.”
- Use it wisely: “Don’t treat your home equity like an ATM machine for purchases you don’t really need,” advises Sharga. “Homeownership is a proven way to build long-term wealth and can even provide financial security for generations. It shouldn’t be squandered on frivolous things. Funds should be used judiciously for things like home improvements, paying off high-interest debt, and education.”
- Shop nearby: HELoan and HELOC terms vary widely, so be sure to explore your options and get quotes from at least three lenders, including both online and brick-and-mortar financial institutions. Talk with your loan officer about which type of financing best suits your goals and timeline.
Final conclusions on utilizing housing assets
Before taking out a HELOC, home equity loan, or cash-out refinance, you should always do your due diligence and think carefully. Especially if you need the funds to pay off student loans or credit card balances, think carefully about your reasons. Are you essentially paying off old debt with new debt? This can be a trap, especially if it means putting assets like your home at risk.
Additionally, many financial experts are concerned about a slowdown and unpredictable interest rates in the coming months. “While the economy has remained remarkably resilient over the past few years, headwinds remain and uncertainty remains high,” Hamrick said. “Taking on more debt at a time when costs are so high carries additional risk.”
Despite all this, drawing down your home equity may still be to your advantage. But before you open the barrel, carefully weigh the pros and cons.
