It’s tempting, but is it necessary? It’s available, but do I want the consequences? Is this the right decision to improve my financial situation or will it lead me into a black hole? Deciding to take equity out of your home can have both advantages and disadvantages.
Maybe you want to remodel your home to avoid having to buy a new home in today’s tough market. Maybe you want to pay off a higher interest credit card or student loan debt. Whatever the reason, if you want to tap into the equity in your home, there are a few things you need to know first.
How much real estate capital do you have?
The first step to accessing home equity is to determine how much equity there is in the first place. Typically, lenders only allow homeowners to borrow up to 80% of the home’s value.
To determine home equity, a homeowner must first know the current value of the home. Most, if not all, lenders will require a formal appraisal of the home, with the fees usually paid by the homeowner. Bankrate.com estimates that the average cost for an appraisal in the United States is $300 to $450, depending on location.
Once the appraisal determines the value of the home, calculate your available home equity. For example, say your home is valued at $350,000 and you have a mortgage balance of $190,000. Your current net worth is $160,000 ($350,000 – $190,000 = $160,000). Knowing that you can only borrow up to 80% of the appraised value, or $280,000 (80% of $350,000 = $280,000), the total amount you can access is $90,000 (280 $000 – $190,000 = $90,000).
Are you eligible to borrow?
Most lenders require a minimum credit score. According to Experian.com, a credit score of around 660 is generally acceptable. However, this will vary by lender and loan option.
Additionally, lenders will assess your debt-to-income ratios (DTIs). To calculate, take the monthly debt payments (mortgage, car loan, student loan, credit card debt, etc.) and divide by the monthly take home pay. If your DTI ratio is over 50%, a lender will be less likely to want to lend you more money.
Which loan vehicle is right for you?
There are three ways to access the equity in your home: a cash refinance, a home equity line of credit (HELOC), or a home equity loan.
- Refinancing by collection. The owner essentially pays off the existing mortgage and replaces it with a new (and larger) mortgage. Using the previous example, if your goal is to access the maximum amount of equity in your home, you would take out a brand new mortgage on your $350,000 home for $280,000; pay off your current mortgage balance of $190,000; and receive $90,000 in cash.
The new mortgage will have a new payment term (usually 15 or 30 years) and a fixed or variable interest rate. Remember that the homeowner will also have to pay closing costs to establish the new mortgage.
- Home equity line of credit. A HELOC is a separate loan in addition to an existing mortgage. The owner has access to the line of credit as needed up to a certain amount. The interest rate will be variable and usually higher than the interest rate you got on your first mortgage. Once you access the money through the HELOC, a second monthly payment will be required. Again, using the previous example, you keep your $190,000 mortgage on your $350,000 house. Plus, you have a line of credit available to draw up to $90,000 with the flexibility to use as much or as little as you need.
- Home equity loan. Like the HELOC, a home equity loan is a separate loan that is added to the existing mortgage. In our example, you would keep your $190,000 mortgage on your $350,000 home and receive an initial lump sum payment of $90,000. Therefore, you will have a separate home loan of $90,000 at a fixed rate and will be required to make a second monthly payment.
One of the advantages of a HELOC or home equity loan over the cash refinance option is the ability to access equity without taking out a new mortgage. In general, there are little or no closing costs associated with HELOCs and home equity loans. Also, if the line of credit or equity loan is used for home improvement purposes, the interest is deductible. Interest is not deductible if the loan funds are used for other purposes (debt consolidation, investment, etc.).
What are the risks of exploiting home equity?
- Regardless of how you access your home equity, your home is the collateral. If it will be difficult for you to make the new mortgage payment or the additional mortgage or equity loan payment, don’t. You could end up losing your home.
- If you use equity to consolidate your debt, i.e. credit cards, you are tempted to accumulate credit card debt again. Re-creating high-interest debt can create a black hole that is usually difficult to get out of.
- Borrow only the amount necessary to meet a specific need. If you borrow the maximum equity in your home without a plan, you risk spending the extra money recklessly.
- If a new mortgage is secured through the cash-out refinance option and the term of the loan to be repaid is extended, you extend the term and increase the amount of interest required to repay the loan. This can delay or eliminate the achievement of your other goals.
Tapping into home equity can be a viable and beneficial financial strategy for many reasons, but also comes with its fair share of risk. Consider getting advice from a CFP® professional if you are interested in accessing the equity in your home.
Abby VanDerHeyden is a Wealth Advisor at Bedel Financial Consulting Inc., a wealth management firm based in Indianapolis. For more information, visit their website at www.bedelfinancial.com or email Abby at AVanDerHeyden@bedelfinancial.com.