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Tapping into Home Equity

Today we are going to discuss Home Equity, what it is, and if it is worth tapping into. The difference between the current value of a home and how much is owed on the mortgage equates to an owner’s Home Equity. For instance, if you have a home worth $500,000 and a current mortgage of $200,000, you would have $300,000 or 60% in home equity.

Home equity has risen recently along with the prices of homes in the US. The national average is now about 70.5% - it is highest level since 1984. To put that number in perspective, 10 years ago, in 2012, home equity hovered at just 46%. During the last 10 years we have seen home prices continually climb with a big jump in the last 2 years which has substantially increased owners to home equity. There are many owners asking the question if it a good time to tap into that wealth?

Considering our recent inflation and possible recession along with corresponding job loss, or many other economic uncertainties this is a reasonable question. Currently, consumer debt is $320 billion higher than a year ago, and combined with tumbling mutual funds and stock market holdings ($4.2 trillion lower than last year), people maybe looking or needing for extra cash. Home equity, is generally available at a lower interest rate than personal loans or other types of lending. Because of this it can make sense to tap into our home equity to fund investments such as home improvement, or further our education, or perhaps start a business. But there really can be a downside to this, these loans have be paid back, either with proceeds from the sale of your home or from other funds, like increased income etc.

While it’s can be very tempting to dip into that capital in your home, just remember you’re not only increasing your debt load, but you’re also reducing the equity in the home that you’ve built. However, there are some smart ways to go about using that money, and smart reasons to do so as well.

You would need to weigh if tapping into your home’s equity helps to reduce other higher interest debt or pay for home improvements that actually increase the value of your home. Short-term rates are going up due to recent actions of the Federal Reserve, so your other consumer debt may be going up quickly as well, like the cost of car loans, of credit card interest. Not only the savings that you can get, but the psychological relief of not having to worry about paying those bills every month may be worth getting a home equity loan.

With skyrocketing interest rates boosting the borrowing costs on mortgages, plus rising rates for home equity options, too. We are seeing changes in the way that homeowners are choosing to tap into the real estate capital. If you are thinking of pulling money out of your house, there are three options most homeowners turn to. We have put together a guide to some of the new rules on tapping home equity, along with some pros and cons:

1. Cash-out refinance

A cash-out refinance involves refinancing your existing mortgage for more than what you originally owed on the house and taking the difference in cash. True to its name, you are “cashing out” some of the equity in your home in order to get the larger mortgage.

For example, back to our first scenario if you have a home worth $500,000 and a current mortgage of $200,000, you would have $300,000 in home equity. Maybe you want to pay down some credit cards or college tuition, so you cash out $100,000 of that equity and get a new mortgage for $300,000.

If your property has risen in value (as most do over time), this also increases home equity. Let’s say your home’s value has risen from $500,000 to $525,000 since you bought it. If, as in the previous example, you owe $300,000 on that loan, you could cash out $25,000 but essentially still keep the same mortgage on $200,000 while pocketing $25,000.

The interest rate on a cash-out refinance is fixed, making monthly payments easier to factor into the budget.Cash-out refinances are a good option for homeowners who want only one mortgage to keep track of and pay off, and also for those who may not have a great credit score. Because they are federally backed by Fannie Mae, Freddie Mac, the Federal Housing Administration, and Veterans Affairs, refinances have less stringent credit score requirements and underwriting than other methods of borrowing against your house.

The process for a cash-out refinance is similar to refinancing a mortgage, but homeowners usually end up paying more in interest after a cash-out refinance over the long term, because they’re increasing not only the amount but also the length of their loan. (For example, if you were already 10 years into a 30-year loan, refinancing for another 30 years means you’ll be paying for 10 years longer than had you kept your original mortgage.) And like a typical mortgage process, they will be paying closing costs, which is typically anywhere between 3% to 5% of the new loan amount.

A year ago, cash-out refinances made up a majority of equity withdrawals thanks to record-low mortgage rates. But with the average rate on a 30-year fixed mortgage topping 7% in October, which is pushing all rates up with it, a cash-out refinance makes less sense today. As interest rates climb, a cash-out refinance—which resets the rate on the total outstanding loan balance—makes less financial sense, people are more likely to use home equity loans or lines of credit, which enable them to tap only a limited amount of equity at today’s mortgage rates, keeping the rest of their mortgage debt at their current rate.

According to the August 2022 Housing Finance Policy Center’s Chartbook, “Higher rates this year have also forced a sharp cutback in cash-out refinances, which had soared in the last two years as some homebuyers used the refinance opportunity to extract equity.”

But now rising mortgage rates have critically reduced cash-out refinance activity significantly Cash-out refinance dropped an estimated 44% from a year ago.

2. Home equity loan

Let’s look at Home equity loans – these may be a better option due to high mortgage rates and are similar to a cash-out refinance, but a home equity loan allows you to borrow against the equity in your home. The biggest difference is that while a cash-out refinance replaces your existing mortgage with a new one, a home equity loan involves taking out a second loan on top of your first.

The interest rate and payments on a home equity loan are fixed, meaning the rate doesn’t change and homeowners will be taking on a steady loan payment each month.

Most mortgage lenders will allow homeowners to borrow up to 80% of their home equity in the form of a home equity loan. For example, if your home is worth that $500,000 we talked about and your mortgage balance is $200,000, you have 60% equity in your property and would be able to borrow up to $200,000 more. Home equity loans tend to have higher credit score requirements and more stringent underwriting compared with a cash-out refinance. But they’re a good option for homeowners who don’t want to touch the great rate on their first mortgage. Plus if you use the loan for home improvements or renovation, the interest may be deductible.

One thing to keep in mind is that with a fixed-rate loan like a home equity loan, you will pay interest on the entire loan amount—even if you’re using it incrementally, such as for home renovation. And if you do end up selling your house, the balance on the home equity loan will be due in full. So let’s take a look and the 3rd option…

3. Home equity line of credit (HELOC)

Similar to a home equity loan, a home equity line of credit (also known as a HELOC) allows homeowners to borrow money and essentially open up a line of credit using the equity in their home as collateral.

The biggest difference between a HELOC and a home equity loan and a cash-out refinance is that a HELOC acts like a credit card. Once approved, homeowners can borrow on an as-needed based, up to the loan’s limit, over and over again through the term of the loan (typically five to 20 years).

Most mortgage lenders will allow homeowners to borrow up to 75% to 85% of a home’s value, minus what they still owe. So, again back to our first example, if your home has been appraised at $500,000 and you still owe $200,000 on the mortgage, the bank will calculate 75% of the value ($375,000 in this case) and then subtract $200,000 (the amount you still owe). They would then set up a HELOC with a $175,000 limit that you can borrow against over time.

Homeowners pay interest only on the amount they borrow over the life of the loan. So if they borrow only $5,000 of their $35,000 credit limit, they pay interest on only $5,000.

The benefit of a HELOC is the flexibility of opening what is essentially a revolving line of credit, which is great for those who aren’t sure how much money they need to borrow, or when they’ll even need to use it. For instance, if you’re planning a home remodel and the project is expected to take six to eight months, you can open a home equity line of credit and pay the contractor over the course of the project, as bills come due.

Some lenders are advocates of taking out a HELOC before you need one because there is no way to predict what the real estate market will do tomorrow and it is the cheapest form of credit that you will probably ever have. A HELOC can work well for someone who needs a large amount of money right away as they can take as little as two weeks to obtain. And they can be used want over and over again without having to go through the mortgage process repeatedly, as long as you pay them down again.

The other benefit of a HELOC: Because they’re a bank product, they don’t include the closing costs associated with refinancing or a home equity loan. The big downside of a HELOC is that the interest rate is not fixed and may adjust (and go up) over time. It can keep going up every month or every time the Federal Reserve raises rates. Although home equity loans and HELOCs each come with their unique pros and cons, both are increasingly popular options today, particularly compared with cash-out refinances right now.

Mistakes to avoid when tapping into home equity

The No. 1 advice right now: If you’re even considering tapping into your home equity in the next year or two, do it now before the rates go up even further—or before home prices start to come down, even slightly.

Houses are sitting on the market longer now. Causing home values to start pull back a little bit. So your home is not going to be worth as much as it was last year. Homeowners considering a home equity ideally should try to catch it at the peak. But perhaps what’s more important is to consider what you’re using the money for in the first place.

Using it to pay for home improvement, investments, college tuition, and higher-interest debt all make sense. Using a home equity loan to buy a boat? Might not be the smartest move. Cashing out equity for things that may not bring value or using your home like a piggy bank to buy a new car is not a smart financial decision, because these things loose equity over time. If, however, the goal is to pay off higher-interest credit cards or other debt, then tapping into equity and taking out a loan or line of credit can make more sense.

If you are considering tapping into home equity in today’s market with rising interest rates, two of the most important things you can do as a homeowner is to compare lenders and see where you can get the best terms and rates. And with a recession looming on the horizon, it’s smart not to overextend yourself financially.


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