The equity in your home represents possibilities. You can choose to tap into that value, giving you funds for a range of needs. But you may be wondering, “Exactly how can I use the equity in my home? Are there rules or limitations?”
Fortunately, the world of home equity isn’t as complex as it might seem. Whether you’re a first-time homebuyer who wants to understand the ins and outs as you build equity or a long-time homeowner with ample equity available, here’s what you need to know.
What Is Home Equity?
In the simplest sense, home equity is the difference between the current value of your home and the amount you owe on your mortgage or another connected loan or line of credit. It’s a reflection of your interest in your home or, in other words, the value of the portion of the house you technically own.
If you’re wondering, “How do you determine the equity in a home?” the process is straightforward. First, you determine the fair market value of your property, often by doing some research into your local market and comps in your area. Next, you total up all the debt where your property is considered collateral, such as mortgages. Then, you subtract the total debt from the house’s fair market value. That’s your home equity.
For example, imagine a home had a fair market value of $450,000. If there is an existing mortgage with a remaining balance of $280,000, the current home equity is $170,000.
Tapping Into Home Equity
When you have equity, tapping its value can help you accomplish other financial goals. However, it’s critical to understand how using those funds works, including the process involved, any potential pros and cons, and the limits on how much you can use.
How to Tap Your Home Equity
If you’re wondering, “How do I get equity out of my home?” the answer can vary. There are several approaches that potentially work, so they’re all worth considering.
First, you could try a home equity line of credit. With this option, some of the value of your home above what you owe on your mortgage becomes the basis for a revolving line of credit. You can access the funds at any time and reborrow any amount you repay, not unlike a credit card.
Second, there are home equity loans. These are essentially second mortgages, offering fixed repayment terms for borrowing a set amount.
Finally, another option for how to take equity from your home is a cash-out refinance. With this, you request a loan amount above what you owe on your existing mortgage. Then, you use a portion of those funds to pay off the current loan, wrapping it into the new one. Any funds above that amount are then yours to use for other purposes.
The Pros and Cons of Using Home Equity
Generally speaking, pulling equity out of your home comes with benefits and drawbacks. On the plus side, it can allow you to access funds with an interest rate usually far lower than many alternatives. Additionally, you typically get longer repayment terms and fixed interest rates, both of which may be beneficial.
Depending on how you use the money, any of that interest could be tax-deductible, too. However, that isn’t universally true.
When it comes to drawbacks, you are technically putting your home at risk. Your property serves as collateral, so failing to repay an associated loan or line of credit could result in foreclosure.
Typically, you’ll also need a sizeable amount of equity. Depending on how you tap into your home equity, you might also incur a range of costs or fees. For example, a cash-out refinance can have closing costs, appraisal fees, origination fees, and more.
How Much Home Equity You Can Access
There are limits to how much home equity you can access at any given time. Generally speaking, lenders require at least 20 percent to remain untapped. That creates a suitable cushion, ensuring that you can repay what’s owed with the proceeds if you need to sell.
What Homeowners Can Do with Their Home Equity
If you’re wondering, “How can I use the equity in my home?” the answer may depend on your situation. In some cases, you can use the funds you acquire using one of the options above any way you’d like. In others, the lender may have some say.
Usually, the latter occurs if your debt-to-income ratio is too high after the proposed cash-out refinance or home equity loan or line of credit is added into the equation. When that happens, the lender may only allow you to move forward if you agree to use some of the equity funds to pay off enough debts. In some cases, the lender may even make a direct payment from them to your other creditor mandatory, ensuring that an appropriate portion of the money goes to the identified debts.
Otherwise, homeowners are typically in control of what happens to the equity funds. Here are some common ways people use the money.
Home Renovations
If you need to update your home, using equity to do it can be a wise move. You’re using your current home value to increase the property’s value even further, which can leave you with a larger equity cushion when all is said and done.
Debt Consolidation
Another popular option is to use home equity to consolidate debt, particularly among homeowners
battling with high-interest debts. Usually, the interest rate on home loans and lines of credit are far
lower than you see with credit cards and personal loans. Plus, you get the added convenience of a single
monthly payment.
Using home equity for debt consolidation is also wise if your home has become unaffordable or you may
face foreclosure. It gives you a chance to tap into what you’ve built. As long as the total amount owed
on your house remains below its potential sale value, you can clear that debt during your home sale.
That frees up even more room in your budget and lets you avoid foreclosure, making it a win-win that
could make starting your new life in a different home easier.
Investing
In some cases, homeowners tap the equity in their house to make traditional investments. That could include funding a retirement account or boosting a portfolio at a traditional brokerage.
Using home equity to invest in this way is generally only wise if you can guarantee higher returns than your mortgage, loan, or credit line interest rate. In that case, you’re making more in returns than you’re spending in interest. However, that’s not always easy to capture, so keep that in mind.
Purchasing Other Properties
Using home equity to buy another home is another popular option. Some homeowners will go this route when they want to purchase another primary house, essentially using equity to ensure they have a solid down payment.
However, that isn’t the only option. Some decide to tap equity to buy property overseas. Others might consider using home equity for a down payment on an investment property.
Overall, using home equity to buy rental property – either wholly or just to support a down payment – can make sense in many cases. If you can receive enough rental income to more than cover the associated mortgage payment, if there is one, it may be a wise move for the money.
Other Financial Goals or Needs
Technically – unless the lender has specific requirements – you can use your home equity for any purpose you’d like. Whether you want to fund your education, take a vacation, replace appliances, or anything else, it’s often fair game.
However, it’s critical to remember that you’re putting your home on the line. Since that’s the case, it’s best to be responsible with the money.
