The Pros and Cons of Tapping into Home Equity
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Owning a home has many benefits. You’ll feel like a part of a community and will have more control and flexibility than tenants. Homeownership is also a common path to wealth since your property gradually gains market value.
Real estate tends to appreciate in the long run due to the limited supply of homes and overall inflation. While inflation reduces the purchasing power of every dollar, it increases the value of tangible assets with limited supply.
Some homeowners borrow money against their homes by tapping into their equity. While receiving an extra windfall can help with covering various expenses, there are some pros and cons to keep in mind before using home equity.
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What is home equity?
Home equity represents your stake in your home. You can determine the amount of equity by subtracting your mortgage balance from your property’s value. Someone with a $1 million home and a $700,000 mortgage balance has $300,000 in home equity.
Once you pay off your mortgage, you have 100% equity in your home. You’ll then become debt-free and have more room in your budget for other expenses. Housing is the biggest expense for most individuals, and building home equity eventually makes it more manageable.
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How do homeowners build equity?
Homeowners don’t have many choices for building equity. Monthly mortgage payments allow you to consistently build equity, but making home improvements also helps. If you renovate a room, your home will become more valuable since that room is more modern.
Individuals also build home equity as their properties gain value. Market conditions can lead to higher property valuations even if you aren’t taking up any home renovation. If the value of your home goes up by 20%, your equity position grows by 20%.
While home improvements let you take an active role in equity building, properties can gain value based on their location. If your area has a growing population, houses will gain value and offer more equity for their owners.
Some of the ways you can use home equity
You can use home equity to cover various expenses. Homeowners don’t have to tell lenders how they intend to use their funds. These are some ideas to get you started.
Debt consolidation
Homeowners usually get lower interest rates when borrowing against home equity than unsecured debt products like personal loans, student loans, and credit cards. Individuals deep in credit card debt can pay off their balances by tapping into their home equity.
Credit card rates have been on the rise, and many cards have rates as high as 29.99% APR. Borrowing capital against your property minimizes interest accumulation and puts all of your debt under one umbrella.
College tuition
The cost of a college education seems to increase every year while outpacing inflation. While scholarships and financial aid can limit the financial impact of college tuition, many students still end up with high payments. Parents seeking to help their children graduate from college debt-free can tap into their home equity to assist with tuition bills.
Medical bills
Medical bills can quickly add up as you get older. In fact, medical expenses are a leading cause of bankruptcy. Building equity in your home over multiple decades can put you in a better position to cover medical costs if they show up.
Vacation
Borrowing money against your property’s value can make a summer vacation easier to afford. You can enjoy a trip to your favorite destination while converting the hotel, flights, and other costs into manageable monthly payments.
Home improvements
You can use some of your home equity to invest in home improvements. These improvements will increase your property’s value and give you more equity for future purchases. You can also decide to let the equity build after making improvements instead of tapping into it again.
Different ways to tap into home equity
You can choose from one of these methods to access the equity you have built in your home. Homeowners have to fulfill a lender’s LTV ratio, Debt-to-income ratio (DTI), and credit score requirements to obtain any of these financial products.
Home equity line of credit (HELOC)
A HELOC is a credit line that uses your property as collateral. You only have to make interest payments in the beginning, and you only accrue interest when you borrow against the credit line. You can use the lump sum right away and have until the draw period to pay it back. Any remaining balance after the draw period gets converted into an installment loan.
HELOCs usually have variable interest rates which makes interest accumulation more difficult to predict. If you pay off your HELOC early, you can still borrow a certain amount of money against it if another expense comes up.
Home equity loan
A home equity loan also lets you borrow money against your house. This loan has fixed monthly payments ranging from 5-30 years. It’s a second mortgage that will increase your monthly expenses. You can use the lump sum right away.
Some people use home equity loans instead of HELOCs due to their predictability. The monthly payment is the same in the first month as in the 10th year. That’s the key advantage fixed interest rates provide. You can also rest assured that your monthly loan payment is chipping away at your principal. Only making the minimum monthly HELOC payment doesn’t have much of an impact on the principal.
Cash-out refinance
A cash-out refinance involves modifying the rate and term of your current mortgage. Some homeowners refinance to capitalize on lower interest rates, get out of debt sooner, reduce monthly payments, or borrow equity. No refinance lets you achieve all four things simultaneously, but you can accomplish multiple objectives with a single refinancing.
For a cash-out refinance, your new mortgage will have a higher balance than your primary mortgage. For instance, if you want to borrow $100,000 and you currently have a $500,000 mortgage, your new mortgage will have a $600,000 balance. The difference between the old and new balance becomes capital you can immediately access.
Homeowners will get stuck with higher monthly payments if they refinance and keep the same loan length. However, you can reduce your payments while tapping into home equity if you extend the duration of your loan. Turning a 10-year mortgage into a 15-year mortgage will reduce your monthly payments since you are spreading the principal across additional monthly payments.
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The advantages of tapping into home equity
It’s your right as a homeowner to tap into your equity as long as you fulfill the lender’s requirements. These are some of the perks of capitalizing on the value your property has accumulated over several years.
Extra cash at lower rates
Borrowing money against your home equity position gives you extra cash you can use for any purpose. That’s a solid perk for any financial product, but you’ll also get a lower interest rate when you borrow against your property.
Lenders assess a borrower’s risk when determining mortgage rates. Tying collateral to the loan or line of credit minimizes the lender’s risk since there is a greater incentive for the borrower to make on-time payments.
If you don’t pay an unsecured personal loan, your credit score will take a hit, and the interest debt can eventually go to a debt collection agency. However, a borrower who falls behind on a home equity loan can lose their property to the bank. That’s a far greater risk, and lenders offer lower rates since they believe loans tied to people’s properties are more likely to be repaid.
Preserve your emergency fund
Some people can pull cash from their emergency funds instead of taking out a home equity loan or a line of credit. However, draining your emergency fund can leave you vulnerable if you incur another surprise expense.
Home equity loans, HELOCs, and refinances can take a few weeks to obtain. That’s because a mortgage lender must conduct due diligence, often including a home appraisal. You can access your home equity and ensure you have extra cash in your emergency fund if another expense comes up.
Access to a revolving line of credit
This advantage caters to HELOCs. You receive a lump sum that you can use for any purchase, but a borrower may repay the HELOC before the draw period concludes. If that happens, and you need extra cash a few months later, you can borrow from the same HELOC. There’s no need to apply for a new loan, incur additional closing costs, or wait several days or weeks to access your funds.
Change your mortgage or keep it the same
Home equity loans and HELOCs let you keep your current rate and term on your mortgage. This setup is ideal if you got a mortgage back when interest rates were at historic lows. However, you also have the option to obtain a cash-out refinance. This refinance changes the rate and terms of your mortgage. Going this route can be more suitable if your credit score has improved significantly since you got your current mortgage.
The disadvantages of tapping into home equity
Home equity gives you plenty of choices, but it’s not always a good idea to borrow against your property’s value. These are some of the downsides to consider.
Closing costs
You have to pay closing costs to access your home equity. Closing costs can range from 2% to 5% of the loan’s balance. If you want to borrow $50,000 in home equity, you can end up with closing costs that range from $1,000 to $2,500.
Some mortgage lenders are more generous than others. However, you will likely have to contend with these extra costs to tap into your home equity.
Lengthier time frame
Getting your loan application approved and receiving funds can take multiple weeks. Mortgage lenders review more information and request a home appraisal during the application process.
Meanwhile, you can get some personal loans in as little as 24 hours. If there is a pressing emergency that requires immediate cash, it can take too long to borrow against your property’s value.
Dealing with a second mortgage
A second mortgage is going to take up space in your monthly budget. You’ll end up with an additional monthly payment if you opt for a home equity loan or a HELOC. It’s too much for some people to juggle both expenses, while others can do it just fine. You should assess your financial situation before committing to a second mortgage.
You will probably stay in debt longer
Borrowing money against your home prolongs your path to owning your home free and clear. Using a cash-out refinance and turning a 10-year mortgage into a 15-year mortgage keeps you in debt for five additional years. If you use a home equity loan with a 30-year term, you’ll stay in debt even longer.
While tapping into home equity can minimize short-term financial challenges, falling into this cycle can create long-term challenges and endless debt. Making an additional monthly mortgage payment can help you get out of debt sooner. You’ll also have more home equity to tap into if needed.
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The bottom line
Owning a home is usually better than renting, especially if you know where you want to live. You’ll build equity with every monthly mortgage payment, and your property can also gain value. You will still have to pay other expenses like property taxes, but eventually, ridding yourself of monthly mortgage payments will free up a lot of space in your budget.
Sometimes, it’s necessary to access home equity. The value you have built into your home can help with many big-ticket expenses. However, it’s good to treat home equity as something that you use as a last resort rather than the default option that enables bad financial habits.
If you borrow against your home equity, it’s a good idea to assess how you got here. Retracing your steps can help you save money, build an emergency fund, and become less reliant on your property’s equity position.
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Writer
Marc Guberti is a business freelance writer who specializes in personal finance, digital marketing, and entrepreneurship. His award-winning book "Content Marketing Secrets" teaches readers how to create, promote and optimize content for growth and revenue. Marc also hosts the "Breakthrough Success Podcast," where listeners learn how to master content marketing and get more clients.
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