Home equity is at an all-time high
Thanks to rapidly rising home values, many Americans are now equity rich.
In fact, a recent report from data firm Black Knight found that the average U.S. homeowner has $153,000 in “tappable” home equity — an all-time high.
That pent-up wealth can be put to work making home renovations, paying off debts, buying new properties, investing, and more.
But how do you actually take equity out of your home? And when is it a good idea to do so?
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What does it mean to have equity in your home?
Having equity means you have cash value built up in your home. Your equity will grow year by year as you pay off your mortgage and as your home (likely) increases in value.
Of course, equity isn’t liquid cash. The wealth built up via home equity is tied into your property’s value.
That means you can’t just spend your home equity. To put the money to work, you first have to convert home equity into liquid cash. This is typically done via a cash-out refinance loan or a second mortgage (more information on this below).
But first, here’s how you can determine whether you have equity available to cash out.
How to calculate your home equity
Calculating home equity is simple. Just take the current value of your home minus your mortgage balance today.
- Suppose your home is worth $350,000
- Your mortgage balance is $110,000
- Your total equity is $240,000 ($350,000 – $110,000 = $240,000)
Note: Your home’s current value likely won’t be the same as what you paid for it unless you bought the property very recently. To get a current estimate — factoring in home price inflation — you can check recent sales prices of similar homes nearby on real estate listing sites, or use an online estimation tool.
What is ‘tappable’ home equity?
Tappable home equity is the amount of money you can actually withdraw from your home’s value via a cash-out refinance or second mortgage. Your tappable home equity is typically equal to your total amount of equity minus 20% of your home’s value.
Returning to our example above, here’s how to find your tappable home equity:
- Home price: $350,000
- Mortgage loan amount: $110,000
- Total home equity: $240,000
- 20 percent ‘buffer’: $70,000 (0.20 x $350,000)
- Tappable home equity: $170,000 ($240,000 – $70,000)
The reason your tappable equity is lower than your total home equity is that mortgage lenders want you to leave 20% of your home’s value untouched. That way, if you were to default on the loan, the lender would be protected financially.
There are exceptions to this rule, mostly for VA loans which may allow up to 100% loan-to-value (LTV). And a few lenders let you retain less than 20 percent.
But for the most part, borrowers should expect to need significantly more than 20% equity to be able to cash out.
Remember that Black Knight estimates homeowners currently have $153,000 in tappable equity on average — even after accounting for that 20% buffer.
How to take equity out of your home
There are three main ways to tap your equity:
- Cash-out refinance — You take out a new primary mortgage to replace your existing loan. The new loan has a larger balance than what you currently owe, and that ‘difference’ is returned to you as cash. Refinance closing costs are around 2-5% of the loan amount on average and are usually taken out of your cash back
- Home equity loan — A home equity loan (HEL) is a type of second mortgage, meaning you keep your existing mortgage in place and take out a second loan against your home equity. HEL closing costs are typically lower, but these loans may have slightly higher interest ates than a cash-out refinance. This may be a good choice if you don’t want to refinance your first mortgage
- Home equity line of credit (HELOC) — Home equity lines of credit usually have variable rates and low or zero closing costs. This is a bit like a credit card in that you get a credit limit you can borrow from and repay over and over. And you only pay interest on any outstanding loan balance. HELOCs have set ‘draw periods’ after which time you have to repay the remaining balance in full
Which type of cash-back loan is best?
That depends on your personal finances and your current mortgage.
Cash-out refinancing is usually best if you want to refinance anyway. Maybe you can get a lower interest rate and reduce your monthly mortgage payment at the same time you take cash out from your equity.
Just note that cash-out mortgages usually come with a slightly higher mortgage rate. So be sure to get quotes from several lenders and run the numbers.
On the other hand, maybe you already have a low mortgage rate — or you’re almost done paying off your original mortgage, so refinancing doesn’t make sense.
In that case, a fixed-rate home equity loan might be a good way to tap some equity without refinancing your home’s entire value. You can borrow only what you need and pay it off in a shorter repayment period.
Another exceptional circumstance can be when you want to borrow a large sum for a short period.
Then, a HELOC might be your best bet. Remember, it costs little or nothing to set up. And you pay interest only on your outstanding balance. So once your need for the loan has ended, you can simply zero your balance and pay nothing more.
You might also consider a reverse mortgage if you qualify, which means you must be age 62 years or above.
A reverse mortgage provides a lump sum and an income, which can be great in retirement. And you don’t have to make any monthly payments. Instead, the loan amount and interest payments are rolled up and fall due only when you die or sell the home. Just be aware that those add up quickly and you may have a lot less wealth to pass on to your heirs.
Reverse mortgages are less common than they once were and should be handled with care. If you’re considering a reverse mortgage, check out the Department of Housing and Urban Development’s advice on the topic.
Benefits of taking equity from your home
When used wisely, home equity can have valuable benefits. That extra cash might help you grow your assets or improve your overall financial health.
For example, taking equity out of your home might allow you to:
- Invest in home improvements that will increase your home’s value
- Consolidate high-interest debts into a single, low-interest loan
- Launch your own startup business
- Cover some urgent medical bills or a family emergency
And now might be a uniquely good time to tap home equity. Because (at least at the time this was written) mortgage rates remain exceptionally low.
That means homeowners can finance these types of big expenses affordably. Borrowing from your home equity could be much cheaper than paying with personal loans or credit cards, for example.
Just make sure mortgage rates remain low by the time you read this.
Drawbacks of cashing out home equity
Of course, there are downsides to cashing out your home equity, too.
For example, tapping your equity inevitably involves a new mortgage (whether that’s a refinanced first mortgage or a type of second mortgage). So you’re putting your home on the line and could lose it if you fall too far behind with payments.
Plus, if you choose a cash-out refinance, you’re resetting the clock on your mortgage.
Suppose you’ve had your existing home loan for 15 years and have another 15 to go. Assuming you refinance to a 30-year loan, you’ll end up paying down your home over 45 years instead of 30. And that means you’ll pay more interest in the long term.
Of course, you could refinance to a new 15-year loan. But expect that to bring significantly higher monthly payments. You can model your own figures using a refinance calculator.
When does it make sense to take equity out of your home?
The mistake you really want to avoid is to take equity out of your home in order to prop up an unsustainable lifestyle. Because, unless you address the underlying issue of overspending, you’re almost certain to end up much worse off sooner or later.
That’s especially true if you cash out for debt consolidation. There’s a good chance you’ll save on debt payments each month. But, before you do it, draw up a household budget that will put your outgoing payments in line with your income. Then resolve to stick to it.
There are plenty of good reasons to take out home equity, some of which we’ve mentioned already. For example:
- Investing in a new or existing business
- Improving your home
- Covering unexpected medical bills while avoiding more expensive forms of borrowing
- Investing in yours or your family’s future by paying for education
Then there are gray areas.
A wedding, fancy car, or vacation of a lifetime won’t give you any financial return. And if you tap equity to pay for these types of things, you’ll likely still be making payments several years (or decades) after the wonderful memories will have faded.
All in all, most financial advisors suggest you don’t tap your equity unless you are going to use the money for “good,” financially beneficial purposes.
What are today’s cash-out mortgage rates?
Cash-out refinance rates are typically a little higher than no-cash-out refi rates. And those for home equity loans and HELOCs are a little higher still.
The good news is, today’s mortgage rates are still near record lows. So even with a small rate bump, homeowners can still get great deals on cash-out financing.
Check your cash-out eligibility and interest rates to see if tapping home equity makes sense for you.