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Congratulations, you did it! You've paid off your home and no longer have the burden of a monthly mortgage payment to worry about. But now you need money for a large unexpected expense, a home remodel or another purpose. If your savings fall short of the amount you need, consider your options, including home equity products.
You could tap into your substantial home equity if your home is paid off with a home equity loan or line of credit (HELOC). But before choosing this path, carefully weigh the pros and cons of borrowing against your home.
How to Get Equity out of a Home You've Paid Off
You own your home outright, so you have 100% equity. Most lenders allow you to borrow up to 80% to 85% of the equity in your home minus your mortgage loan balance. With a $0 mortgage balance, you could be eligible to borrow as much as 85% of your home's equity. That means if your home is worth $450,000, you may borrow up to $382,500 ($450,000 x 85%).
If you need to access your equity, here are some options to consider:
- Home equity loan: Home equity loans are fixed-rate installment loans that usually allow you to borrow up to 80% of your home's equity, but some online banks and credit unions extend the cap to 100%. If approved, you'll receive one lump-sum payment you can use for virtually any purpose and repay the loan in fixed monthly payments. Like HELOCs, home equity loans are considered second mortgages because they are the second lien (after your primary mortgage) against your property, which serves as collateral on the loan. But without an existing mortgage, these home equity loan products become the first lien against your property.
- Home equity line of credit (HELOC): A HELOC works like a credit card, allowing you to borrow as much and as often as you like up to your credit limit. This revolving line of credit usually comes with variable interest rates and includes a draw period, usually 10 years, during which you can draw on your line of credit as needed while making interest-only payments. Once the draw period expires, you'll enter a repayment period. You'll no longer be able to withdraw cash, and you'll either need to repay the loan—generally over 20 years—or refinance the loan.
- Cash-out refinance: A cash-out refinance enables you to convert your home equity into cash. Typically, a cash-out refi involves replacing your current mortgage with a new, larger one and using the surplus to pay off debt, cover a home remodel or for virtually any legal purpose. But if you own your home outright, there is no current mortgage to pay off, so you can receive the entire loan amount—usually up to 80% of your home's value—as cash.
Pros and Cons of Borrowing Against Your Home
Tapping into your home equity can help you address an immediate financial need, but it may have consequences. Before getting a loan on a paid-off house, weigh the benefits and downsides to help you make the best decision.
Pros of Borrowing Against Your Home
- You have access to your available equity. Owning a paid-off home usually means there are no liens on your property. The reduced risk may make it easier for a lender to approve you for a home equity loan or HELOC.
- Your interest rates may be low. Home equity loans, HELOCs and cash-out refinance loans are all types of secured loans, meaning your home serves as collateral. Because your lender carries less risk with secured loans, you may qualify for a lower interest rate than a credit card, personal loan or other financing options. Ultimately, the rate you receive will likely depend on your overall creditworthiness.
- You may get a tax break. You may qualify to deduct the interest you pay on a home equity loan or HELOC if you use the funds to buy, build or make significant improvements to your home. And by reinvesting in your home, you could boost the value of your property.
- Your repayment term is longer than other types of credit. Home equity loans, HELOCs and cash-out refinances typically have longer repayment periods than other financing options, often up to 30 years. Longer repayment periods can lower your monthly payment amount, although you may pay more interest over the life of the loan.
- You can borrow only as much as you need. It's never wise to pay interest on money you don't need. That's not a problem with a HELOC, as you can draw only the amount you need from your line of credit.
Cons of Borrowing Against Your Home
- You're putting your home on the line. As a general rule, HELOCs and home equity loans are considered second mortgages that use your home as collateral to secure the loan. However, if you own your home outright, your home equity or HELOC becomes the first lien against your property. In either case, you could lose your home if you fall behind on the payments or default on the loan.
- You're no longer free and clear. A home equity loan or HELOC can provide a substantial amount of money you may need, but it comes with an obvious trade-off: Borrowing against your home will reintroduce monthly payments—and the potential stress that comes with it—into your finances.
- You may need to pay closing costs. As with your original mortgage, home equity products typically come with closing costs and fees, adding to the total cost of your loan. For example, closing costs on home equity loans and HELOCs typically range from 2% to 5% of the amount you borrow.
- You could end up with negative equity. If you get a new loan or HELOC and your home value drops, you could owe more than your home is worth. As a result, it could be harder to sell or refinance your home.
5 Things to Consider Before Tapping Into Equity
Converting your home equity into cash while using your home as collateral is a big decision, especially when you own your home outright. Before choosing this path, ask yourself some vital questions, such as:
- How will you use the equity funds? Understanding how you'll use the money can help you determine which type of equity product is best for your situation. For instance, a home equity loan could make sense if you need to fund a substantial expense. But a HELOC may be a better option if you're funding a long-term project with ongoing costs. On the other hand, if you need money for a vacation or a purchase that will depreciate, it may not be worth risking your home at all.
- How much money do you need? With a home equity loan or HELOC, you might qualify for a sizable sum—anywhere from tens to hundreds of thousands of dollars. But it's essential to borrow only as much as you need to save on interest and help make your monthly payments more manageable.
- Can you afford the new monthly payment? Before signing for a new home equity product, review your monthly budget to ensure there's adequate room to comfortably afford a new payment. Keep in mind, most (but not all) HELOCs come with variable interest rates, so you may need to prepare for interest rate fluctuations that could increase your payment.
- How long will you be in debt? Home equity loan and HELOC terms often stretch up to 30 years, but shorter terms are often available. Consider the length of your repayment term and if you're comfortable being in debt for that long, especially after you've enjoyed the freedom of being mortgage-free. If you can swing the higher monthly payments, a shorter-term loan could save you on interest and might be a better choice.
- What alternatives are available that don't put my house at risk? While credit cards and personal loans usually have higher interest rates than home equity products, they don't require you to use your home as collateral. If your retirement plan allows for it, you may be able to borrow from your retirement account, although that option can hamper your retirement savings growth.
The Bottom Line
It is possible to take out a HELOC or home equity loan on a paid-off house, but deciding whether you should do so likely depends on your financial situation and goals. Borrowing from your home can come in handy if you need the funds, but it comes with a cost—the risk of losing your home. That's a big pill to swallow, especially if you value the freedom of not having a mortgage payment.
Remember that your credit score and history will have a lot to do with whether you qualify for a home equity product with favorable interest rates and terms. Before you proceed, check your Experian credit report and credit score for free to help you determine if tapping into your home equity is worth it for you.