Before you dive into using the equity of your home, it’s important you know exactly what it is. Home equity is the share of the house that the homeowner actually owns. This equity share can increase if the value of the property increases or if the mortgage loan is paid down or off. If you borrowed money to purchase the house, the lender also has a share of equity in the home until the loan and interest are paid back in full.
These days, equity is viewed not only as a valuable savings tool, but also a potential finance tool. While lenders do require a homeowner to maintain at least 20% equity in the home in case housing prices fall—like they did during the housing crisis—it can be a useful financial tool if you need:
- To make home improvements
- Pay for education
- Require more money for retirement
- Pay off other debts
- Pursue investments
- Personal spending (which we would not advise)
Below, we will discuss how to use the equity in your home as a smart financial tool.
The Three Home Equity Paths
It is crucial to view home equity as an asset, which means it is a substantial portion of your net worth. This grants you the ability to take lump-sum or partial withdrawals out of your equity if necessary, and there are a variety of ways one can use those assets.
Those who desire to take out money on their home equity are technically taking out a second loan on their home. There are three such secondary home loan avenues to choose from. Each of these paths depends upon the individual’s goals and their specific financial circumstances. If you want your money to go further, carefully evaluate your savings and spending habits before you take any drastic actions.
These are typically referred to as home-equity loans and are structured in a very similar fashion to a primary mortgage. Second mortgages can come with a range of fixed interest rates, most of which will be naturally higher than the original mortgage and have a set term. Use a reverse mortgage calculator to see what this would end up looking like for your own personal finances.
Since all of the money in a home equity loan is withdrawn at once, most people who use these require the money immediately—whether this is for educational, medical, debt, or investment purposes.
Home Equity Line of Credit
HELOCs are the most flexible home equity loan in that you do not withdraw any funds unless necessary. If you do, you draw from this line of credit as you would a credit card. These loans generally come with a checkbook or debit card that grants access to these funds. These loans only have payments on actual money paid and have no closing costs.
A home equity line of credit is ideal for homeowners who expect that they will have intermittent needs to withdraw cash for things like home improvements, repairs, or starting a home business. This is the cheapest type of equity loan since you only pay interest on what is borrowed. Just make sure that you repay the total balance prior to the term expiration.
Cash Out Refinance
With a cash-out, you are not automatically taking out a second loan, although such a method is not uncommon in order to circumvent primary mortgage insurance. In such cases, you refinance your home for a higher amount and pocket the extra cash. These types of loans often have high closing costs.
A cash-out refinance is advisable for the people who have already gained a substantial portion of equity in the house, need the money immediately, and also qualify for a better rate than on the previous mortgage. If your credit score has improved significantly since that initial home loan, then the new, lower rate can offset the larger payment that is tied to the newer loan. This can also improve cash flow if this money is used to satisfy other debts and loans.
Using the equity in your home can be a wise financial move. Just be careful and thorough as you forecast your budget, your needs, and future cash flow before you make that commitment. That being said, we would never advise someone to use home equity to pay for vacations, a new car, or monthly expenses. Such a serious step should be saved for those who truly need the money to pay for important life expenses.