How and When to Tap into Your Home Equity

Homes in a suburban neighborhood

Key takeaways

  • Cash-out refinance loans are best for those that need a lump sum and don’t mind taking on higher mortgage payments.

  • HELOC acts as a credit card that uses equity as a source of funds.

  • Home equity agreements are an option as well; it's not a loan, and has no monthly payments or interest.

There is a reality that is ever-present for most homeowners: they are saddled with debt – particularly credit card debt. Americans’ total credit card balance was $841 billion in the first quarter of 2022, according to the latest consumer debt data from the Federal Reserve Bank of New York. Combine this credit card debt with student loans, medical debt, auto loans and other forms of debt and you can understand why the collective debt of the American household has soared past 15 trillion.

The good news is there are solutions. You can tap into your home equity to access liquidity that can aid you in your mission to eliminate debt.

Look at this mountain of debt.

A graph showing American household debt from 2019-Q1 2022

What is home equity?

Let’s start with the basics. Home equity is the difference between the current market value of your home minus anything you owe on the property, including liens and loans (such as your mortgage). Initially, home equity is obtained as soon as you put a down payment on the property. From there, your home equity rises if you pay off your mortgage and your property value appreciates.

Tap into your home equity with a cash-out refinance

A cash-out refinance (cash-out refi) replaces your current mortgage with a new, larger loan in an amount more than what you currently own on your house. You receive the difference in cash, and can use that money for whatever needs you have. This option, considering the recent rise in interest rates, is a much less popular choice right now.

What you need to know about cash-out refinance

It’s important to consider the costs of a cash-out refinance before making a decision on this option. With cash-out refi you are taking on a larger mortgage, which – depending on the interest rate you receive – may mean larger monthly payments for the duration of the loan, which is often 15 or 30 years. Additionally, you should consider any prepayment or cancellation penalties, and closing costs that average two to five percent.

How do you know if cash-out refinancing is for you?

The best ways to determine if this method is for you are to consider the interest rate you will receive, the monthly payment and the reason why you need to tap into your home equity. For instance, if you’re goal is to use the cash to fund a college education, it may make sense if the interest rate you receive is lower than student loan interest rates.

Tap into your home equity with a HELOC

Another alternative is a home equity line of credit (HELOC), which uses your home’s equity as a source of funds and allows you to borrow funds as needed up to a certain limit.

Who qualifies for a HELOC?

You must meet the lender’s requirements. Typical requirements include:

  • A credit score that is no lower than 620. Ideally, a score of 700 or higher is best.

  • A maximum DTI of 43% or lower.

  • A maximum LTV of 85%.

  • Equity in your home of at least 15-20%.

What you need to know about HELOCs

HELOCs come with minimum draw requirements and annual fees, and often have substantial prepayment penalties. If the value of your home decreases, then lenders can reduce your credit line or revoke it completely.

Defaults on loans can lead to home foreclosure. HELOCs are loans with adjustable rates, which means the interest rate on your HELOC will fluctuate based on the market.

How do you know if a HELOC is for you?

If you are unclear about how much you need to borrow and when you need it, a HELOC may be a good choice. If you need a large sum of cash at one time, a home equity loan may be an option.

Home equity loans

Home equity loans differ from HELOCs in that they are not lines of credit. Instead, they allow homeowners to receive a lump sum of cash up front, then pay it off with monthly payments and interest.

Who qualifies for a home equity loan?

Once again, you must meet the lender’s loan requirements. Typical requirements include:

  • A credit score that is at least 620 or higher.

  • A maximum DTI of 43% or lower.

  • A maximum LTV of 85%.

  • Equity in your home of at least 15-20%.

What you need to know about home equity loans

Home equity loans are secured by using your home as collateral, which generally means lower interest rates than with an unsecured loan (like a personal loan). However, HEL rates are still higher than HELOC rates, on average.

HELs also have closing fees of about three to five percent of the loan amount. Home equity loan defaults can lead to foreclosure.

How do you know if a home equity loan is for you?

For homeowners who require lump sums for their financial goals, this is a valid option. If you plan to use the funds to consolidate and pay off other high-interest debt (like credit card debt), a HEL can be a good choice. If you are not sure how much money you need or when, then a HELOC is better option.

Reverse mortgages allow you to tap into home equity

A reverse mortgage transfers home equity to allow homeowners of a certain age limit to amplify their retirement income. The best time to utilize this loan is during retirement. The loan is due at the end of the agreed-upon period, or when the homeowner moves out or passes away.

Who qualifies for a reverse mortgage?

To meet the lender’s loan requirements, you must:

  • Be 62 years of age or older.

  • You must own your home outright, or have a single primary lien on your home.

  • A maximum LTV of 50-65%.

What you need to know about reverse mortgages

With a reverse mortgage, homeowners are still responsible for paying taxes and insurance on the property and must use the property as their primary residence for the loan’s duration.

How do you know if a reverse mortgage is for you?

There are no monthly payments associated with reverse mortgages. However, there are some considerations to keep in mind. Homeowners who want to leave their property to their family should know that those who inherit the property will take on their debt if they have not paid back the loan before they pass away.

If homeowners are unsure if they can keep up with property tax and insurance, then they risk foreclosure. Also, lenders expect the payment in full if homeowners must leave their home for assisted living or nursing homes.

Tap into your home equity with a home equity agreement

A home equity agreement (HEA) is not a loan, and has no age requirement. HEAs allow you to receive cash now in exchange for the HEA provider receiving a share of your home’s future value.

Who qualifies for a home equity agreement?

In general, homeowners must have a maximum LTV of 75%, and at least 25% equity in their home, and a credit score of 600 (although some providers, like Unlock, work with those who have scores in the 500s).

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