Homeowners across America have access to a record-high of $11.5 trillion in tappable equity, according to data solutions and analytics company, Black Knight, Inc. Tappable equity is defined as the sum that homeowners can borrow while still holding on to 20% equity of their home’s value.
If you are among these ranks of home-equity rich but cash-poor homeowners, now may be a good time to leverage your home’s equity and take advantage of low interest rates to make short-term investments, such as home improvements, paying for college, or even investing in a business.
What is home equity?
Home equity, in simple terms, is the difference between your home’s market value and what you still owe on the property. It’s generally spoken of in terms of percentage — the aforementioned difference between your home’s market value and what you still owe on it, divided by the total current market value of your home.
Home equity can also be referred to as a number: i.e., the dollar amount of your home’s market value minus its unpaid mortgage amount.
For example, if you own a house worth $350,000 and have $50,000 dollars left to pay on the mortgage, you would have $300,000 dollars in home equity (85% equity).
One of the most important measurements of home equity in determining if, and for how much, you qualify for a home equity loan is your “Combined Loan to Value” ratio (CLTV). Lenders use a home’s CLTV as an important tool to determine the risk of lending to potential borrowers — and how much tappable home equity they have to offer as collateral.
To calculate your CLTV, simply calculate the sum of all mortgages secured by your house and divide it by that house’s market-valued price.Homeowners can typically borrow up to 85% CLTV of their home’s equity through a loan before lenders may start charging higher interest rates, depending on their creditworthiness.
This range differs from lender to lender, as each lender evaluates the risk they are willing to take slightly differently based on your credit history, the market value of your home, and how much you earn. The higher your CLTV, the more existing loan you have in relation to the market value of the house, and thus the riskier your home equity loan application appears to a lender (and vice versa).
Going back to the example of a $350,000 house, at this point you have $300,000 of home equity and your CLTV at this point is 14.3% ($50,000 divided by $350,000).
If we assume that your home equity loan lender has a max of 80% CLTV at which they will lend to you at market rates, you can typically borrow money using your equity as collateral — as long as your combined mortgage loan amount on that collateral stays within $280,000 (80% of $350,000). But since you still owe $50,000 on your first mortgage, your effective tappable home equity is $230,000 ($280,000 minus $50,000).
“You can use your equity in a home to invest in another property — or really anything you want, unless the lender restricts you to a certain item. However, there is no usual requirement as you’re using your own home’s equity,” states Reef Merhi, loan officer at Texas United Mortgage.
A home equity loan is essentially a type of second-mortgage — assuming your first mortgage has not yet been paid off — in which you are using your house as collateral for a secured loan.
Secured loans vs. unsecured loans
A secured loan is simply a loan that requires the borrower to use an object of equal or greater value as collateral in case the borrower defaults on their loan. In that case, the lender has the legal right to take possession of the collateral and sell it to recoup the money they lost to the borrower’s default.
The lender is guaranteed to not lose their money invested — or at least as much as they otherwise would — regardless of whether the borrower can make payments or not.
Conversely, unsecured loans are simply loans given out on the basis of a borrower’s evaluated creditworthiness without the promise of collateral as a safety net for the lender.
Because home equity loans by definition are secured by the borrower’s house, they often offer homeowners more competitive interest rates than unsecured loans such as personal loans or student loans.
How can you leverage home equity toward a loan?
Home equity loans are most often taken out on homes that are already promised as collateral to their first mortgages. Lenders of first mortgages have first claim to possession of your house in case of default, while home equity lenders have second.
Meaning, if the market value of the house falls so that it’s less than both the first mortgage and second mortgage (your home equity loan), your home equity lender is the one who is most concerned they won’t be paid back.
Home equity loans generally offer interest rates lower than unsecured loans but higher than first mortgages.
There are two main types of home equity loans: fixed-rate home equity loans and home equity lines of credit.
What is a fixed-rate Home Equity Loan?
Fixed-rate home equity loans are the most simple to understand: You receive a lump sum cash payment through the loan by using your home as collateral. If you default on your loan, your home may be foreclosed on.
Every month you make a fixed payment, interest and principal included, toward repaying your loan for the duration of your term — generally about five to 15 years.
Be warned that interest is charged on the whole sum of the loan starting from when it is disbursed, no matter how slowly or quickly you use up those funds (or for what purpose).
Your interest rate is fixed at the market rate at the time you took out the loan so that the amount you pay every month is the same. This predictable monthly payment amount is an attractive feature of fixed-rate loans because it can be easily factored into your financial planning.
If you have a steady source of income, fixed-rate home equity loans are the best for specific one-time expenditures with a known cost — the most common being home improvements or maintenance.
“If I’m remodeling my kitchen, and I know I’m going to have a fixed cost of $50,000 and I’m more comfortable with a fixed-rate [then] I might go with a home equity loan instead of a home equity line of credit,” says Ian Grove, associate advisor for Robert Green & Company, who previously worked in mortgage banking for 15 years.
What’s more, your home equity loan can help get the most out of your tax refund.
Home equity loan borrowers can deduct the interest paid on a limit of $750,000 of funds used to “buy, build, or substantially improve the taxpayer’s home that secures the [home equity] loan,” according to the IRS. If you are married and filing a separate return, you and your spouse can each deduct the interest on (up to) $375,000 of funds specific to this purpose.
You can renovate your kitchen or install a new security system and write off the interest paid in your tax return — increase your home’s market value and upgrade your quality of life in one fell swoop.
Though the 2017 Tax Cuts and Jobs Act enforced stricter restrictions on the amount and type of interest deductible on spending from your home equity loan ($750,000 down from the previous limit of $1,000,000), it’s still worth filing for any amount of tax deduction.
Please consult an accountant or tax advisor to fully explore your home improvement deduction options.
What is a Home Equity Line of Credit?
A home equity line of credit, or HELOC, uses your home to secure a loan just as a fixed-rate home equity loan does but differs in how it disburses funds and its terms of repayment.
“When most people think of a home equity loan, they’re thinking of a HELOC: a home equity line of credit,” says Grove. “It’s easiest to think of the analogy of a credit card that’s secured to your home. You can charge up a credit card [aka withdraw funds from it] and pay it back down, and the interest is going to be based on a revolving amount.”
A HELOC operates similar to a credit card
It provides you with a revolving line of credit so you can continuously draw funds (and pay them back) up to a certain limit, without reapplying for a loan. HELOC is a variable interest loan with monthly payments that fluctuate according to changes in market interest rates, but are generally lower than fixed-rate home equity loans and often have lower fees.
Imagine you took out a first mortgage of $100,000 on a house valued at $200,000 and were approved for a $100,000 HELOC. You chose to draw $50,000 from the HELOC for kitchen renovations — you now have $150,000 of combined mortgage debt against your house.
Grove continues: “You can charge that $50,000 down over time by paying back your HELOC debt, or charge it back up again [by withdrawing more].”
A HELOC charges only for what you borrow
Once approved for HELOC, a borrower has an “active draw” period of five to 10 years during which you can borrow as much of or as little of that approved loan amount — and you’re charged interest only on what you borrow. Often the minimum payment required during the draw period will be very low, close to interest only — though you can choose to make larger payments so that you can borrow more while staying under your credit limit.
At the end of your active draw period, the line of credit closes and you aren’t able to borrow any more money. You then enter the “repayment” period of 10 to 15 years wherein you make monthly payments that go toward both principal and interest— these payments vary from month to month depending on the market interest rate.
Plan to borrow within your means — or your future-predicted means if you are using a HELOC to invest in your business or other venture with a predicted return higher than your home equity loan rate.
Alternatives to home equity loans include personal loans and cash-out refinancing.
Let’s consider: fixed-rate Home Equity Loans vs. HELOC
First, to understand the differences between fixed-rate home equity loans and HELOC, let’s explore what they do.
A fixed-rate home equity loan:
- Disburses a lump sum of cash at the time your loan is approved; this one-time payment is a good source of low-interest cash for many financial situations (e.g., debt consolidation).
- Begins to charge interest as soon as funds are paid to the borrower, no matter how or when you use them.
- Consistent monthly payments: Payments are locked in at the same interest rate (the market interest rate at the time you took out the loan); makes it easy for a borrower to factor payments into their financial budget.
- Best for one-time expenditures with a known cost (e.g., home improvement).
Meanwhile, a HELOC loan:
- Allows you to borrow funds, pay them back to replenish the available credit to be drawn on, and borrow more as long as you stay within your credit limit; this flexibility is a convenient source of cash for many situations.
- Charges interest only on funds drawn on, not total credit limit approved.
- Variable monthly payments: Payments fluctuate depending on the market interest rate every month; this interest rate is based on the prime rate, plus a margin as determined by the lender.
- Payments may increase suddenly after the draw period closes and the repayment period begins.
- Depending on the lender, may be eligible to convert some borrowed funds to be repaid in fixed-rate payments (sometimes at a fee).
- Often has lower origination and closing fees than fixed-rate home equity loans.
- Best for situations where you may need to borrow-as-you-go (e.g., paying college tuition every semester).
Now that we understand the differences, it is important to explore which is best suited for different scenarios.
“They serve different purposes for different situations,” states Grove. A fixed-rate home equity loan has slightly higher interest rates than a HELOC and often times more fees, but guarantees the borrower stable repayment conditions where every monthly payment is the same.
“You eliminate the rate fluctuating with the market … but again you lose the flexibility of a HELOC [that lets you borrow as much or as little cash],” Grove continues.
Similarities between all home equity loans
Both fixed-rate home equity loans and HELOCs may be tax-deductible and offer lower interest rates than unsecured loans such as credit card debt, student loans, or personal loans.
Some borrowers choose to “consolidate” their high-interest unsecured debt with a low-interest rate secured loan.
For example, some borrowers choose to pay off credit card debt and personal loans with the funds from a home equity loan — at which point they still owe a monthly payment to only one lender (their home equity loan lender).
In this way you are effectively changing your debt obligations to multiple lenders to one lender, and lowering the interest rate at which you pay your debt back.
But be cautious: If you default on your home equity loan, your house may be foreclosed on or you may be sued by your lender. In both cases, a default will mean a heavy hit to your credit score.
Though large financial institutions may have more resources to offer better terms, small institutions may be more open to negotiating these terms with individuals in the first place.
When Jenkins was looking to borrow money to invest in real estate, he says, “I found that the large banks were less willing to work with me. They all claimed to be [busy and] couldn’t be flexible in their terms or what they offered.The smaller banks and credit unions were a lot more flexible and gave better terms and rates.”
To conclude, home equity loans are a great way to leverage the untapped equity built up in your home to borrow funds at a low rate.
It’s a worthy consideration to consult with a financial advisor and call up a few banks or credit unions before agreeing to sign.
Depending on what you are using your loan for — a one-time expenditure, investment purposes, or even as a source of emergency cash — a fixed-rate home equity loan or a HELOC may offer more competitive interest rates and lower fees for a homeowner looking for a reliable source of quick cash.
*Figures in example rounded to the nearest hundred for simplicity.
How much can you borrow with a home equity loan? A home equity loan generally allows you to borrow around 80% to 85% of your home's value, minus what you owe on your mortgage.What is not a good use of a home equity loan? ›
It's not a good idea to use a HELOC to fund a vacation, buy a car, pay off credit card debt, pay for college, or invest in real estate. If you fail to make payments on a HELOC, you could lose your house to foreclosure.What is the smartest thing to do with home equity? ›
Paying off high-interest loans or investing the money back into your house via upgrades or repairs can be a fruitful way to spend equity. For example, if you need a large amount of cash but don't want to change your first mortgage, a home equity loan might be a more attractive option.What is a disadvantage of taking out a home equity loan? ›
Home Equity Loan Disadvantages
Higher Interest Rate Than a HELOC: Home equity loans tend to have a higher interest rate than home equity lines of credit, so you may pay more interest over the life of the loan. Your Home Will Be Used As Collateral: Failure to make on-time monthly payments will hurt your credit score.
Credit score: At least 620
In many cases, lenders will set a minimum credit score of 620 to qualify for a home equity loan — though the limit can be as high as 660 or 680 in some cases. However, there may still be options for home equity loans with bad credit.
Home equity loans, HELOCs, and home equity investments are three ways you can take equity out of your home without refinancing.Can you borrow 100% of your home equity? ›
To qualify for a home equity loan, in many cases your loan-to-value (LTV) ratio shouldn't exceed 85%. However, it's possible to get a high-LTV home equity loan that allows you to borrow up to 100% of your home's value.How much a month is a 50000 home equity loan? ›
Loan payment example: on a $50,000 loan for 120 months at 8.00% interest rate, monthly payments would be $606.64.Is a home equity loan a good idea right now? ›
Taking out a home equity loan can be a good idea if you need money to fund life expenses such as home renovations, higher education costs or unexpected emergencies. Home equity loans tend to have lower interest rates than other types of debt, which is a significant benefit in today's rising interest rate environment.Is it worth cashing out home equity? ›
If your home value has climbed or you've built up equity over time by making payments, a cash-out refinance might make sense for you. Cash-out refinancing is a very low-interest way to borrow the money you need for home improvements, tuition, debt consolidation or other expenses.
Building home equity is important because it decreases your debt and increases the money you have stashed away in assets, which is a strong way to build financial stability. Beyond that, you can also leverage home equity to borrow money at a lower interest rate.What do most people use home equity for? ›
Home equity can be used for more than renovating or fixing your home, including paying for college, consolidating debt and more. Home equity loans are pretty straightforward: You borrow money against the amount of equity you have in your home.What do most homeowners use the equity in their home for? ›
Home improvement is one of the most common reasons homeowners take out home equity loans or HELOCs. Besides making a home more comfortable for you, upgrades could raise the home's value and draw more interest from prospective buyers when you sell it later on.
Tapping into the equity in your home can be a great way to pay off debt, cover the cost of home renovations or even pay for a vacation or medical bills. One of the most common ways homeowners can access equity is through a home equity line of credit or HELOC.What is the average interest rate on a home equity loan? ›
Home equity loans have fixed interest rates, which means the rate you receive will be the rate you pay for the entirety of the loan term. As of Jan. 18, 2023, the current average home equity loan interest rate is 7.77 percent. The current average HELOC interest rate is 7.73 percent.Does a home equity loan count as income? ›
First, the funds you receive through a home equity loan or home equity line of credit (HELOC) are not taxable as income - it's borrowed money, not an increase your earnings. Second, in some areas you may have to pay a mortgage recording tax when you take out a home equity loan.How long do you usually have to pay off a home equity loan? ›
How long do you have to repay a home equity loan? You'll make fixed monthly payments until the loan is paid off. Most terms range from five to 20 years, but you can take as long as 30 years to pay back a home equity loan.How long does it take to get a home equity loan approved? ›
The truth is that home equity loan approval can take anywhere from a week—or two up to months in some cases. Most lenders will tell you that the average window of time it takes to get a home equity loan is between two and six weeks, with most closings happening within a month.What is the difference between a HELOC and a home equity loan? ›
A home equity loan allows you to borrow a lump sum of money against your home's existing equity. A HELOC also leverages a home's equity but allows homeowners to apply for an open line of credit. You then can borrow up to a fixed amount on an as-needed basis.Do you have to pay taxes on equity when you refinance your home? ›
The IRS doesn't view the money you take from a cash-out refinance as income – instead, it's considered an additional loan. You don't need to include the cash from your refinance as income when you file your taxes.
Refinancing your mortgage does not have to impact your home equity. If your home appraises for $250,000 and you owe $150,000 on your mortgage, refinancing that mortgage does not change the fact that your home is worth $250,000.Can I use home equity to pay off debt? ›
A home equity loan allows you to convert a portion of the equity you've built in your home to cash. It's also an effective way to consolidate debt and eliminate high-interest credit card and loan balances sooner. That's because the average interest rate on home equity loans is often lower than that of a credit card.What is the least you can borrow on a home equity loan? ›
What's the Smallest Home Equity Loan or HELOC You Can Get? Home equity loans and home equity lines of credit (HELOCs) typically require you to borrow a minimum of $10,000. Borrowing against your home poses risk, so consider alternative options like a personal loan—especially if you only need a small loan.Can you pay off a home equity loan early? ›
Make sure you check with your lender before you decide to pay off your loan early. Typically you won't face a prepayment penalty for contributing a small amount above the required monthly payments, but you should read your loan agreement carefully and discuss the terms with your lender before making a decision.Can I borrow money against my house? ›
A home equity loan is a secured loan – lenders loan you the money secured against the value of your home. They are sometimes referred to as homeowner loans. An alternative to home equity loans is home mortgage refinancing.Will interest rates go down in 2023? ›
Most housing experts say they're hopeful that interest rates will level off in 2023 to around 5% to 6%, but others say the increases will likely continue into early 2023 until inflation is lower.Is it better to refinance or get home equity? ›
If your current mortgage is satisfactory, home equity loans can be a less expensive option for consumers who need access to cash, while refinancing may be a way to lower monthly payments or save money on interest.What is the best advantage of a home equity loan? ›
Pros of a Home Equity Loan
A fixed interest rate with set monthly payments for a fixed period of time. Lower interest rates than many other common forms of debt. Easy-to-obtain large sums of money that you may not qualify for through other avenues.
Home equity loans have fixed interest rates, which means the rate you receive will be the rate you pay for the entirety of the loan term. As of Jan. 11, 2023, the current average home equity loan interest rate is 7.75 percent. The current average HELOC interest rate is 7.72 percent.Does opening a home equity loan hurt your credit? ›
New credit lowers your score
When you take out a loan, such as a home equity loan, it shows up as a new credit account on your credit report. New credit affects 10% of your FICO credit score, and a new loan can cause your score to decrease. 4 However, your score can recover over time as the loan ages.
How long do you have to repay a home equity loan? You'll make fixed monthly payments until the loan is paid off. Most terms range from five to 20 years, but you can take as long as 30 years to pay back a home equity loan.How long is the process for a home equity loan? ›
The entire home equity loan process takes anywhere from two weeks to two months. A few factors influence the timeline—some in and some out of your control: How well you're prepared. Your lender will want to see copies of your current mortgage statement, property tax bill, and proof of income.Is there a better option than a HELOC? ›
A home equity loan is a better option than a home equity line of credit (HELOC) if: You know the exact amount that you need for a fixed expense. You want to consolidate debt but don't want to access a new credit line and risk creating more debt.Do you need an appraisal for a HELOC? ›
When you apply for a HELOC, lenders typically require an appraisal to get an accurate property valuation. That's because your home's value—along with your mortgage balance and creditworthiness—determines whether you qualify for a HELOC, and if so, the amount you can borrow against your home.Is it better to have a HELOC or refinance? ›
If you want to pay less upfront, HELOCs may be a better option. This is because refinancing incurs closing costs, while HELOCs typically do not. When calculating closing costs, you should also consider private mortgage insurance, or PMI, as it applies to refinancing.Is it smart to take all the equity out of your home? ›
DON'T take out excessive equity.
Also keep in mind that a home equity loan or line of credit decreases the amount of equity you have in your home. If you have taken out too much equity and the real estate market drops, you can end up losing all the equity in your home.