Homeowners

In Need of Cash? Three Ways to Unlock the Equity You’ve Built in Your Home

When faced with unplanned expenses, the first financing solution many people turn to is a credit card. However, homeowners may have access to more cost-effective options.

Home equity loans, such as cash-out refinances, Home Equity Lines of Credit (HELOCs), and second mortgages may be a way for homeowners to obtain cash at lower interest rates than credit cards or personal loans.

“Many homeowners can tap into different types of financing that feature lower interest rates than most credit cards and personal loans,” said Cleveland-area real estate professional Tom Schroth of Schroth Realty Group. “Tapping into the equity they’ve built in their homes gives them a lot of flexibility and can also save a lot of money.”

There are three main types of home equity financing. Here’s a look at how each of these loans works, along with their advantages and disadvantages.

Cash-out refinances help homeowners access their equity

A cash-out refinance replaces your existing home mortgage with a new, larger loan. At closing, you will pocket the difference between the two loan amounts. Then you repay the new loan each month, just like you did with your previous mortgage.

You can typically borrow up to 80% of your home’s value minus the outstanding balance on your previous mortgage.

For example, if your home is worth $500,000 and your outstanding mortgage balance is $250,000, you could take out a new mortgage for $400,000 (80% of $500,000) and use $250,000 of this to retire the mortgage balance. You would then receive a lump-sum cash payment of $150,000 if you qualify.

“With a cash-out refi, you don’t have to sell your home in order to benefit from the equity,” said Schroth. “My clients often use cash-out refis to pay off and consolidate high-interest debt like credit cards or to pay for major home renovations like bathroom and kitchen renovations, new HVAC systems, and finishing their basements.”

There are a few potential drawbacks to a cash-out refi to consider. Namely, it will increase the mortgage balance and monthly payment while reducing home equity and extending the loan term.

If a homeowner has been making payments on a 30-year mortgage for 10 years and then assumes a new 30-year loan via a cash-out refi, they will end up making payments for 40 years if they stay in the home that long.

Home Equity Lines of Credit provide cash only when you need it

A Home Equity Line of Credit (or HELOC) is a revolving line of credit secured by the equity you’ve built in your home. Instead of receiving a lump sum like with a cash-out refi, you’ll be able to borrow money up to a preapproved credit limit during the draw period.

The draw period typically lasts five to 10 years and then it’s paid off over the next 10 to 20 years.

You can typically borrow up to 65% to 85% of your home’s value less the outstanding mortgage balance (i.e., your home equity).

One benefit is that you only pay interest on the money you borrow. As funds are repaid, they become available for you to use again as new financial needs arise. HELOCs feature variable interest rates based on the prime rate plus several percentage points.

“It’s often smart to take out a HELOC before you actually need to borrow money,” said Schroth. “This way, the money is sitting there and waiting for you when a financial need arises. In contrast, cash-out [refinances] are usually used to meet a specific financial need that arises.”

Keep in mind that there are risks involved with taking out a HELOC. Since your home is being pledged as collateral, you could face foreclosure if you’re unable to make payments on the loan.

So, it’s important to only borrow what you can realistically afford to repay and to make your payments on time every month.

Second mortgages allow you to keep your existing home loan

A home equity loan, also sometimes called a second mortgage, is similar to a cash-out refi in that you will receive a lump-sum cash payment once you’re approved. But instead of replacing your existing mortgage with a new one, you will take out a second mortgage in addition to your current one.

Homeowners typically need to have at least 15% to 20% equity in their properties to be eligible for the loan.

Many homeowners use proceeds from a second mortgage to consolidate high-interest debt, make home repairs and renovations, and pay for medical expenses or their children’s college or private school educations.

Home equity loans feature fixed interest rates and consistent monthly payment amounts, which makes budgeting easier. Like HELOCs, they pose the risk of foreclosure if you are unable to repay the loan.

How to choose the right home equity loan

So, which type of home equity loan is right for you?

“The answer depends on a number of different factors such as how much equity you have in your home, how long you plan to remain in your home, and whether you will use the money for short-term or long-term purposes,” said Schroth.

Carefully weigh the pros and cons of each home equity loan to make the best decision based on your circumstances.