Building up home equity remains one of the key benefits to purchasing a home. That equity — the amount of the home’s value you own less the mortgage debt still owed — can provide a key source of cash when needed. For example, the proceeds from drawing from home equity could be used to pay off major expenses or renovate or upgrade your house.“Rather than buying a new house, a lot of people will remodel and do upgrades to their house,” said Tendayi Kapfidze, chief economist for LendingTree, the parent company of MagnifyMoney.
However, home equity should not be treated as a secret stash under the mattress. There can be real benefits but also real drawbacks to tapping home equity. It’s important to research and evaluate those pros and cons prior to deciding to do this.
When it comes to drawing funds from your home equity, there are three primary ways to do so. These are a home equity loan, a home equity line of credit, HELOC, and a cash-out refinance.
Home equity loan
Simply put, a home equity loan provides the homeowner with a total loan amount at one time. That loan amount is determined by a variety of factors, including the amount of equity in the home, the homeowners’ income and credit history and market value of the home. This loan must be repaid within a specified term with a fixed interest rate, resulting in a set monthly payment amount.
The pros of a home equity loan include a lower interest rate compared with rates for other types of loans. Even as we enter a rising interest-rate environment, interest rates on home equity loans continue to be less than those of other loan types because the loan is secured by the home. Also, because the monthly payment is set, homeowners know what they are expected to pay and can budget accordingly for the term of the loan.
The primary con of a home equity loan is the risk of using the home as collateral. As such, if the homeowner is unable to pay off the loan, the lender may foreclose on the loan, forcing the homeowner to sell. Home equity loans also include a variety of associated costs, such as an appraisal of the home, application fees, title fees and other costs. Plus, because you receive all the money upfront, interest on a home equity loan starts to accrue from day one.
Because the lender approves a maximum amount for the home equity loan, the homeowner may be tempted to take out a loan for the full approved amount, even if it’s more than what is needed. But this could overextend the homeowner, making it more difficult to repay the loan.
Home equity line of credit
Another way to tap into home equity is through a home equity line of credit, HELOC. Similar to a credit card, a HELOC is a revolving line of credit based on the amount of home equity you have. Like a credit card, there is a maximum amount available, although the homeowner is not required to use it all at once like a home equity loan. Instead, you can draw upon the HELOC as needed up to the full approved amount.
Also like a credit card, a HELOC is repaid using a minimum monthly payment amount with interest. That interest rate could be fixed or variable. If variable, then those monthly payments could vary as well.
One key differentiator of a HELOC comes when the balance is due. Many HELOCs require a balloon payment — the majority of the final balance — at the end of the loan term. This could be difficult to pull together in a short period of time.
Like a home equity loan, the pros of a HELOC include lower interest rates as well as low, or no, fees, depending on the lender. And, unlike the “once and done” withdrawal of a home equity loan, the homeowner has flexibility to draw upon the HELOC as needed up to the maximum amount. As such, interest only accrues when money is owed on the line of credit.
Of course, a HELOC shares the same primary con as a home equity loan in that the homeowner uses the property as collateral. Therefore, if the homeowner fails to make payments, the home could be at risk. And because the HELOC may have a variable interest rate, that rate may increase, thus increasing the overall costs of the HELOC.
At their discretion, lenders may lower or freeze a line of credit over the course of the loan term. This could result from a declining credit score or a poor payment history for the homeowner.
Previously, another benefit to a HELOC was claiming the interest on lines up to $100,000 as an itemized tax deduction. However, after December 2017, this benefit was changed under the Tax Cuts and Jobs Act of 2017. Going forward, interest on lines up to $100,000 may be deducted only if the money is used for home improvement projects. Interest on any monies from a HELOC used for other expenses cannot be deducted.
Homeowners also have the option of doing a cash-out refinance of their current mortgage in order to tap their home equity. Essentially, you build up equity in your home through payments on the principle of your existing mortgage as well as through an increased home value.
As a result, your current home equity may be more than what you owe on your current mortgage. If so, you can refinance your current mortgage for more than what you owe, using that money to pay off the first mortgage and pocketing the difference.
The reasons for a cash-out refinance include lowering the interest rate or using the cash for renovations or to pay specific expenses like college tuition or medical costs.
For many, lowering the interest rate is a primary motivator for a cash-out refinance. But Kapfidze warns against looking at the interest rate alone. If you have one rate for your existing mortgage that has a remaining term of 20 years, and the cash-out refinance comes with a lower interest rate for 30 years, do the math to determine if you are actually paying more with the cash-out refinance.
“You almost have to calculate a blended rate,” Kapfidze said.
With a cash-out refinance, the cons could stack up. This loan operates like a primary mortgage, so the same costs, like appraisal fees and closing costs, are included plus the possible addition of private mortgage insurance, PMI, premiums. Also, because you’re borrowing a larger amount than you previously owed, the loan term may be longer on a cash-out refinance.
Making a choice
When choosing the best way to withdraw cash from your home equity, it’s important to research each avenue for tapping into home equity and evaluate the pros and cons of each. Take it a step further, and consider why you want the loan.
“The way to approach it is to figure out which loan best suits your particular need of what you’re trying to do and utilize that loan,” Kapfidze said. “It really depends on the individual circumstance of what someone is planning to do with the money.”
Part of the selection process should also examine repayment of the debt, regardless of which you choose. “Make sure you have a plan for how you’re going to pay it back,” Kapfidze said. “Make sure it fits in with your overall financial profile.”
This article contains links to LendingTree, our parent company.