With the unexpected nature of life, there may come a time when you find you need some extra cash but simply don’t have it lying around. Using your home’s equity is convenient, valid option homeowners can exercise to access needed cash.
Whether you’re taking equity out of your house to buy another house, fund a home renovation or consolidate your debts, you can turn your equity into cash via a number of different loan options. But is it a good idea to take equity out of your house? Let’s explore equity and how it can be used.
Home equity is how much of your home that you own. When you have a mortgage, you share ownership of your home with your lender. But you gain ownership and build equity over time as you pay the loan off. Equity is important, as it is an asset that helps build wealth. This is because the value of your home generally increases over time, which is not the case with all assets. With a house, you’re paying off a loan and building ownership as the home’s value goes up. With a car, for example, you’re paying off a loan and building ownership as the car’s value goes down. And when you sell your home, your equity determines how much money you make on the sale. The more equity you have, the more money you will make. If you sell your home after you’ve paid off your mortgage, you will keep 100% of the money and your lender will make nothing.
And as mentioned above, you can leverage your equity to borrow money if you need cash. With your home equity as collateral, you can take out a home equity loan, a home equity line of credit, reverse mortgage and cash-out refinance. Each option will give you access to cash.
Called a second mortgage, a home equity loan is like a regular mortgage. With a home equity loan, the lender gives you a lump sum which you then pay off (with fixed-rate interest) in regular monthly installments until the loan is paid. With this option, your home is an asset for you and your heirs, as you retain your equity and pass the home onto your children. But it also means that your home is collateral, so you can face foreclosure and lose it if you default on your loan.
There is no age requirement to qualify for a home equity loan, but you need at least 20% equity in your home. You are required to pay interest on the full loan amount, which is tax-deductible (for years 2018-2025), but only if the money is used for qualified purposes--building, buying, or improving your home.
A home equity loan may be the better option if you are under 62 but still need/want to use your equity to cash in; you are looking for short-term money, can make monthly payments, and prefer to keep your equity in your home; you are employed with a stable income; you want the tax benefits from repaying the loan.
A lesser-known option is the HELOC, which is like a standard credit or debit card, allowing you to withdraw up to a certain credit limit as needed. You pay it back monthly based on your interest rate and the amount you borrow. With a HELOC, instead of paying interest on the full loan amount, you only pay interest on what you withdraw. But the interest rate is variable and can change, so you won’t always know what your next payment will be.
Just like with home equity loans, the interest is tax-deductible only if the money is used for the qualified purposes mentioned above. The HELOC also has no age requirement, but you must have 20% equity.
And while a HELOC may have lower costs, interest, and fees, it’s also riskier than the other options. The lender can cut you off and require full repayment at any time. And if you can’t repay it, that means you’ll likely need to sell the home. This is really only a good option if you are going to stay in the home for a short time.
A reverse mortgage is the opposite of a standard mortgage. Instead of borrowing money and paying the lender back in monthly payments, the lender pays you (a lump sum, monthly payments, a line of credit, or a combination of the three), and the loan is paid back years later via the ultimate sale of the house. This loan doesn’t need to be paid back for as long as you live in the house, which allows you to keep the title and continue living in your home. But if you sell, pass away, fail to pay property taxes and insurance, or move out for over a year, the loan is due.
And ultimately, when the home is sold, the lender keeps the proceeds to cover what they loaned you, with the remaining equity/money from the sale going to you/your surviving heirs. Over the course of the loan, interest accumulates and your equity decreases, because the lender buys more and more of your home. As time goes on, there may not be much equity left for your children to inherit. This means the home isn’t really an asset for you.
Interest grows over time and is added to your monthly balance. Most reverse mortgages have variable rates, which means that interest rates may change. Interest is not tax-deductible until you pay the loan off. And since you keep the title, you are responsible for all home maintenance, utilities, taxes, and other expenses. Failure to insure or maintain the home could result in a foreclosure or the lender requiring you to repay the loan. And of course, not having much equity could be an issue if you need money from the sale of the house to pay for a nursing home or other eldercare.
To qualify for a reverse mortgage, you must be 62, and you must own your home outright or have a small remaining balance on your mortgage. There is no income requirement, but there can’t be any other liens or loans on the home.
With a cash-out refinance, you replace your current mortgage with a new, bigger mortgage. This is not the same as taking out a second mortgage, because you’re not paying off two mortgages. Instead, you are replacing the old mortgage with a new one. You basically borrow a larger amount than you currently owe and use that money for whatever you need.
This may be a good option if interest rates are low (preferably lower than your current mortgage), but beware of closing costs and compare them to the cost of the renovation. If your renovation budget is less than or the same as the closing costs, a cash-out refinance might not be worth it. And be aware that with a cash-out refinance, your new loan starts over regardless of how much time you have left on your original mortgage.
Using your equity is a big decision. And that’s because, like all investments, there’s a risk. As with all loans, failure to repay the loan could result in foreclosure and losing your home altogether. While your home’s value will generally increase over time, it is possible it could decrease, such as if the housing market crashes, if you let your home fall into disrepair, or if you experience damage from a natural disaster. With a reverse mortgage, if you die, anyone else living in the home may be displaced. And with a home equity loan/HELOC, if your home value decreases, you could be underwater on your loan, meaning you owe your lender more than the value of the home. In addition, if you sell a home that is cross-collateralized (meaning using collateral from one loan as collateral for another loan), the remaining property will have to support your debt.
Remember, equity is an asset and one that can be used for your benefit. Of course, there is no hard and fast rule as to when or whether or not a homeowner should convert that asset into cash. It depends on your situation and your reason for considering it. But there are certainly some situations when it can be helpful. For example, if you are buying a second home or an investment property, taking out a loan may give you enough cash to cover the down payment. So you wouldn’t need to dip into your savings like you probably had to for your first home. This can be especially helpful if you are interested in building a real estate portfolio, investing in property, or owning several properties.
Tapping into your equity is an easy and convenient way to get cash. But it may not be the best choice for everyone, especially if you’re doing it for unnecessary reasons, like taking a trip or throwing a lavish party. In many cases, it may be advisable to keep paying off your loan as is and find savings elsewhere to pay for whatever you need. But if you do take out a loan, be smart, educate yourself, and talk to an expert to give you the best advice on your situation.