Key takeaways
- Despite the potential benefits, tapping into home equity carries several risks, including putting the homeowner’s property at risk, the potential to fall into significant debt, and the dilution of a valuable asset.
- The unpredictable nature of the housing market and high interest rates are also considerations for not borrowing against a homeâs worth.
- Financial experts advise homeowners to consider how theyâll use their home equity, to always prioritize emergency savings and paying down debt, and to shop around for rates.
Youâre feeling the need for some extra cash â with inflation and the high cost of living, who isnât these days? â and it occurs to you that a worthy source of funds could be within your own house.
The old homestead has a record amount of equity, as its fair market value has increased and youâve faithfully made your mortgage payments, building up your ownership stake. (In fact, nearly half of U.S. mortgaged residential properties are âequity rich,â meaning their ownersâ mortgage balance is less than half their homeâs worth, according to property data analyst ATTOM.) So it can be tempting to tap into it via a home equity loan, HELOC or cash-out refinance.
Truth is, though, it may not be a good idea to pull equity out, even if you have sound uses for the funds. The reasons range from the timely (the relatively high interest rate environment) to the eternal (the risks of hocking your house for cash); from current economic forces (an uncertain real estate market) to individual finances (the dangers of a debt overload). Hereâs what to consider when tapping home equity â and why you may or may not want to.
What is home equity?
According to the Federal Reserve, American homeowners collectively have amassed nearly $32 trillion in home equity as of the fourth quarter of 2023. Individually, the average mortgage-holding homeowner has an equity stake worth around $300,000. Since lenders typically let you borrow around 80 percent of your stake, that translates into as much as $240,000 worth of available funds, or âtappable equity,â as the financial pros say.
Approximately two-thirds of this tappable equity is held by homeowners with credit scores of 760 or greater. Higher scores are significant for lenders because these homeowners are more likely to repay their loans, making them lower-risk borrowers.
How do you tap into home equity?
Before we delve into the pros and cons, a quick refresher on the basics. There are three primary ways to tap the equity stake youâve accrued: a cash-out refinance of your mortgage, a home equity line of credit (HELOC) or a home equity loan.
Cash-out refinance
With a cash-out refinance (refi for short), you take out a new and bigger mortgage to replace your existing one. The difference between the two loan amounts is the cash youâll pocket at closing, which equates to some of the equity youâve accrued in your property (your lender may require you to keep at least 20 percent equity in your home). Your new loanâs outstanding principal will be higher than that of the loan it is replacing, but you can opt for a shorter or longer term.
âFor example, if you owe $100,000 on a home thatâs worth $200,000, you can take out a new mortgage for $150,000 and take the remaining $50,000 of equity as cash,â says Rick Sharga, president/CEO of CJ Patrick Company, an Irvine, Calif.-based business advisory firm. âBut itâs important to realize that this will increase your debt, from $100,000 to $150,000 in this example, and will generally result in you paying more interest over time.â
Youâll also have to pay closing costs, as you would with most refinances.
HELOC (home equity line of credit)
A HELOC works as an adjustable-rate revolving line of credit that lets you tap your homeâs equity as cash for any purpose you desire. Itâs somewhat like using a credit card â only, instead of your debt being unsecured (as it is with plastic), youâll be required to put your home up as collateral. As with a credit card, you borrow what you need at a time of your choice (though thereâs a finite draw period), repay what you owe, and borrow again if you choose.
With a HELOC, your credit limit will be based on your available home equity; you can typically borrow up to 80 or 85 percent of the value of your home (not counting your unpaid mortgage balance). During the draw period â often the first 10 years â youâll be required to pay monthly interest on any amount you borrow, but your funds will be replenished as you repay the principal. During the repayment period, funds are no longer accessible and youâll be obligated to repay the principal and interest over 10 to 20 years, on average.
âThis is one of the most common ways homeowners access their equity,â says Seth Bellas, a home loan specialist for Churchill Mortgage. âMany people use a HELOC to make a major purchase, do a home renovation, or for debt consolidation. Itâs typically more affordable than a cash-out refinance, and the rate and limit are much more attractive than a personal loan or credit card.â
A HELOC has a variable interest rate that changes as the prime rate shifts â often, from month to month â so your overall balance and monthly payments will fluctuate too.
Home equity loan
A type of second mortgage, a home equity loan is taken out against the equity in your home. As with the HELOC, your home becomes collateral for the debt (meaning you could lose it if you donât repay the loan); unlike the HELOC, you borrow a set amount, which is paid out in a lump sum at closing.
âUsing the previous homeowner example [owing $100,000 on a home thatâs worth $200,000], they could borrow $50,000 against the equity in their home and begin making monthly payments on the second loan in addition to their primary mortgage loanâs monthly payment,â Sharga says. Terms vary, but home equity loans can be repaid over as long as 30 years.
âA homeowner with a very good interest rate on their current mortgage loan might consider this option rather than a cash-out refinance, as the latter could charge a higher interest rate,â Sharga continues. Lenders often charge a lower interest rate for home equity loans compared to the rates on personal loans and credit cards. âBut second mortgages tend to have higher interest rates than primary mortgages, so borrowers should factor this in before using this option,â he adds.
$1.3 trillion
The collective gain in equity among U.S. mortgage-holding homeowners in 2023 â a 8.6% increase over the previous year
Source:
CoreLogic
Reasons not to use your home equity
Just because you can tap your home equity with any of the methods above, it doesnât mean you should â even if you intend to use the money wisely, such as toward a home improvement project that will increase your propertyâs resale value. Some of the reasons have to do with the current economic climate, and some are more evergreen and individual, relating to personal finances.
Interest rates remain relatively high
Ponder this reason for postponement: Borrowing money is more expensive right now compared to a few years ago. At the beginning of 2022, interest rates on home-collateralized loans ran in the 4-to-6-percent range, compared to 8 to 10.5 percent in May 2024. âHomeowners must reorient to the new reality that home equity borrowing is not low-cost debtâ anymore, says Greg McBride, Bankrateâs chief financial analyst.
On the positive side, interest rates for home loans and mortgages have stabilized of late, and are forecast to decline further in 2024. Still, âwhile the peak in rates might have been seen, or is at hand, the Federal Reserve has yet to reverse the steep tightening of recent years aimed at containing historically high inflation,â notes Mark Hamrick, senior economic analyst and Washington bureau chief for Bankrate.
Translation: the Fed could raise interest rates again if inflation isnât licked. And even if it doesnât, the low-low rate days are over. Hamrick cautions that continuing elevated interest rates on home equity products may result in sticker shock if you pursue one.
Home equity lines of credit, which charge fluctuating interest, are particularly vulnerable. âKeep in mind that HELOC rates increase every time the Federal Reserve [increases] the federal funds rate. Itâs risky to take on a debt that, in the short term, will only grow more expensive because of inflation,â says Bellas.
You can fall deeply into debt
Another reason to kick a home equity tap down the curb is that youâll be piling on to your total debt, possibly making it more challenging to afford repayment of all of your unpaid balances in the months and years ahead. âTapping into equity increases your overall debt and what you will owe your lender â both in principal and interest â over time. So itâs important to weigh short-term benefits versus long-term costs,â notes Sharga.
HELOCs in particular can be a trap. âMany homeowners find it difficult to stay disciplined in paying down the principal on their line of credit, which can make for a significant interest expense down the road,â Bellas says. During the initial draw period, âmost HELOCs only require you to pay down the interest every month, similar to how a credit card has a minimum payment. By the time the full repayment is due, you will have not only your principal to pay back, but also interest on that principal, making it a pretty steep hill to climb if you arenât in a great financial position.â
And your financial position could become less-than-great through no fault of your own. A high degree of uncertainty continues to characterize the current economic environment, Hamrick notes. If the economy stumbles or a negative event emerges in the months ahead, job loss and interrupted incomes could cause difficulty for many individuals and households. âGiven the high rates of interest that prevail, taking on more debt could be a less-than-optimal decision for some,â he says.
The housing market and home values are unpredictable
If youâve followed the residential real estate scene closely in 2023, youâll know that sales and asking prices fluctuated in different parts of the country. In 2024 so far, home price gains have hit an all-time high, making home affordability â and availability â worse than ever.
âWith mortgage rates still high and the supply of homes constrained, the outlook for home prices is somewhat uncertain,â Hamrick points out.
Especially since real estate is extremely local. Even amid 2023âs overall appreciation in home values, there were geographic slowdowns: Texas actually posted an annual home equity loss. The risk of taking equity out of your home gets especially keen if your local market prices are moving downwards, Sharga emphasizes. âYou might ultimately find yourself owing more than your home is worth,â he notes.
Being in such a state of negative equity is rare, but it can happen, if thereâs a sharp prolonged drop in local real estate prices, and youâre carrying a substantial amount of debt.
Youâre putting your home on the line
With home loan products, the debt you rack up is secured (that is, backed by something) â namely, your home. But that also makes the risk greater. Defaulting or being delinquent on other debts is unpleasant and louses up your credit report and score, but thatâs it. Here, on the other hand, youâre essentially mortgaging your property, which is probably the biggest single asset you have. Sharga recommends you ask yourself: Is it worth possibly losing your home to foreclosure in the event market conditions worsen or your personal financial situation deteriorates?
Consider, too, that when you liquidate equity, you dilute your homeownership stake. That makes your property a less valuable asset and decreases your overall net worth.
Tapping into equity increases your overall debt and what you will owe your lender â both in principal and interest â over time. So itâs important to weigh short-term benefits versus long-term costs.
â Rick Sharga, CEO at CJ Patrick Company
Tips for tapping into home equity
If you are seriously pondering cashing in some of your homeâs equity, here are some tips to follow.
- Have a substantial stake: Hamrick says homeowners in the best position to use home equity are those who have accumulated a substantial amount of it â meaning the value of their home is much higher than the amount remaining to be paid off on their mortgage. âThis typically includes people who have been in their homes for a long time and have not often refinanced. They should also have a high degree of confidence about their job and income security,â he adds. âThose who have only been in their homes a short time should wait until they enjoy a higher level of home equity.â
- Use it wisely: âDonât treat home equity like itâs an ATM for purchases you donât really need to make,â advises Sharga. âHomeownership is a proven way to build up long-term wealth â even providing financial security for multiple generations â and shouldnât be wasted on frivolous things. Funds should be used judiciously for things like home improvements, paying down higher interest rate debt, or education.â
- Shop around: HE Loan and HELOC terms vary widely, so definitely explore options and garner quotes from at least three lenders, including both online and brick-and-mortar institutions. Discuss with the loan officer which type of financing would best suit your purposes and timetable.
Final word on tapping into home equity
You should always do your due diligence and consider carefully before committing to a HELOC, home equity loan or cash-out refinance. Think carefully about your reasons, especially if you want the funds to pay off student loans or credit card balances: Are you basically clearing old debt with new debt? That can be a trap, especially if it means risking an asset like your home.
In addition, many financial experts are concerned about a recession and unpredictable interest rates in the coming months. âWhile the economy has remained surprisingly resilient over the past couple of years, headwinds remain and uncertainty is still high. A good offense for taking ownership of oneâs personal finances translates to maintaining a good defense. That means prioritizing emergency savings while paying down debt,â recommends Hamrick. âTo take on more debt when it is so costly carries additional risk.â
Despite all this, drawing out your home equity still might work for you. But weigh the pros and cons carefully before you tap the keg.
FAQ
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When you borrow to buy a home, your equity is initially equivalent to the down payment you make. The larger your down payment, the greater your initial equity. Over time, you build more equity by paying down the principal balance of your mortgage. Additionally, home improvements that increase your homeâs resale value and market appreciation also boost your equity.
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Your homeâs equity isnât the only option if you need to access funds. Unlike home equity loans and HELOCs, personal loans and credit cards are unsecured debts that donât require using your home as collateral. While personal loans and credit cards usually have higher interest rates, the application process is typically simpler and faster. You might not be able to borrow as big a sum as with a home equity product, but if your need is for $25,000 or less, these methods might actually be preferable.
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