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If you have a significant amount of equity in your home, you may be able to access some of it through a home equity loan, home equity line of credit (HELOC) or cash-out refinance loan.
Most lenders allow you to borrow up to a combined loan-to-value ratio of 85%, which means that your primary mortgage loan and your second mortgage loan—or just your refinance loan—can't exceed 85% of the value of the home.
If you're thinking about using some of your home equity to fund home renovations, consolidate high-interest debt or anything else, here's what you should know about your choices.
With a cash-out refinance loan, you're replacing your primary mortgage loan with a new one. Your new loan amount will be higher than the remaining balance on your original mortgage, and you can take the difference in cash. Like other types of home equity financing, your new loan may have new terms, a new interest rate and a new monthly payment.
Let's say you owe $200,000 on your $400,000 home and you want to access $100,000 of the equity to do some home renovations. Assuming you're paying the loan's closing costs separately, your new mortgage loan will be $300,000, and you'll receive the $100,000 in the form of a check or wire transfer.
- A cash-out refinance typically offers lower interest rates than home equity loans and HELOCs.
- It may allow you to secure a lower interest rate on your primary home loan.
- Primary mortgage loan interest charges are tax-deductible.
- Closing costs are applied to the full loan amount, not just the amount you're taking out in cash.
- It'll increase your costs if you can't secure a lower interest rate than what you're paying now.
Who Should Consider a Cash-Out Refinance?
Cash-out refinances can be worth considering if you can also score a lower interest rate than what you're currently paying. So, if your credit has improved or mortgage rates have dropped since you first took out your mortgage loan, it could be a good option.
But because of higher closing costs, it might not be worth it if you're not planning on living in the house long enough to recoup those upfront fees. That's especially true if the interest rate is higher on the new loan.
Home Equity Line of Credit (HELOC)
A HELOC is a revolving line of credit that allows you to borrow against your equity as you need it rather than all at once, similar to a credit card.
You'll receive a credit limit and can take draws from the credit line as you need the money throughout the draw period (usually 10 years). You'll only pay interest on the amount you borrow, and during the draw period, you can generally make interest-only payments.
Once the draw period ends, you'll enter the repayment period, during which you can no longer take draws from the line of credit.
- You only pay interest on the amount you borrow rather than the full amount of credit available to you.
- Interest-only payments during the draw period can provide you with some flexibility.
- Closing costs are typically low or nonexistent.
- HELOCs typically charge variable interest rates, which means the cost of borrowing can increase over time if market rates go up.
- HELOC interest is only deductible if you use the funds to buy, build or substantially improve the home you're using to secure the loan.
Who Should Consider a HELOC?
A HELOC may be worth considering if you want access to credit but don't need all of it at once. It can also help if you need some flexibility with lower payments during the first months or years of the HELOC term. If you're concerned about variable interest rates, some lenders allow you to convert some or all of your balance to a fixed interest rate with a fixed repayment schedule.
HELOCs may not be the right fit if you're planning to borrow for a one-time expense or project. Additionally, they're not as attractive during times of rising interest rates.
Home Equity Loan
A home equity loan is an installment loan that offers a lump-sum payment upfront, which you'll pay back over a fixed period of time. Unlike a cash-out refinance, this loan is in addition to your primary mortgage loan.
- Home equity loans typically come with fixed interest rates, giving you more certainty about your monthly payments.
- Long repayment terms can offer low monthly payments.
- Closing costs are calculated based on the home equity loan amount, making them less expensive upfront than a cash-out refinance.
- Home equity loans typically come with higher interest rates than cash-out refinance loans and HELOCs.
- Home equity loan interest is only deductible if you use the funds to buy, build or substantially improve the home you're using to secure the loan.
- You may not need all the money upfront.
Who Should Consider a Home Equity Loan?
If you only need funds for a one-time expense or project, a home equity loan can be a better option than a HELOC. You may also consider this option if you can't secure a lower interest rate on a cash-out refinance than what you're paying right now or if you want to avoid higher closing costs.
However, a home equity loan might not be the right fit for you if you can get better terms with one of the other options or if you prefer to have ongoing access to your equity rather than a lump sum.
How to Calculate Your Home Equity
Because lenders typically limit how much you can borrow with these home equity financing options, knowing how much equity you have can help you get an idea of how much you can borrow.
On the surface, calculating your home equity sounds simple. Take your home's current value and subtract your mortgage loan balance, and that's what you have to work with. But while you can easily check your mortgage balance by looking at your latest statement or logging in to your online account, getting the value of your home will cost you.
You can use websites like Zillow or Redfin to get an estimate of your home's value, but that will only give you a ballpark figure. You can even run a comparative analysis of similar homes in your area that have recently been sold. But even that won't give you an exact figure.
When you apply for a cash-out refinance, home equity loan or HELOC, lenders will require an appraisal to get a definitive fair market value. The cost of an appraisal can vary depending on where you live, but the average cost can be as much as $420, according to HomeAdvisor.
With an appraised value in hand, the lender will let you know how much you can borrow.
How to Build Home Equity
Over time, you'll naturally build equity in your home as its value increases and the balance on your mortgage loan decreases. However, there are a few ways you can accelerate your efforts:
- Make renovations to the home. While you may not be able to afford large renovation projects without a home equity product, you may be able to make smaller renovations that can help increase the value of your home.
- Pay more toward your loan. Consider adding extra cash to your monthly mortgage payments or paying every two weeks to pay down your loan more quickly.
- Get a new home appraisal. If it's been a while since your home has been appraised, it's likely increased in value since then. Additionally, if you disagree with an appraiser's valuation, you can file a dispute and provide evidence of what the appraiser missed in their process.
Work on Your Credit to Save Money
Regardless of which home equity product you choose, it's important to look for ways to maximize your savings. While shopping around is an important step in the process, your best bet is to come to the table with a solid credit history.
Review your credit score and credit report to understand your situation and look for opportunities to improve your credit before you apply. While some adjustments can take time, others can produce quicker results. The important thing is that you take your time to prepare your credit before you apply and carefully research all of your options to determine which is best for you.