In this article:
How to get equity out of your home? Here are the four most popular ways:
- Cash-out refinance
- FHA 203(k) refinance for home improvements
- Home equity loan
- Home equity line of credit
Any of those could be perfect — or damaging. Read on to discover which suits you best.Verify your new rate (Feb 28th, 2020)
What is equity?
Equity is simply the amount by which the current market value of your home exceeds your mortgage balance today. If your property value is $200,000 and you owe $100,000, the difference between its worth and its value equals your home equity.
Your loan-to-value (LTV) ratio would be, in that case, 50 percent. because the $100,000 loan divided by the $200,000 value equals .5, or 50 percent.
If your mortgage balance exceeds the property value, as occurred in many places during the Great Recession, you are said to be “underwater” or have “negative equity.” Fortunately, that’s not the case for most of us.
How much can you borrow?
While working out how to get equity out of your home, you need also to consider how much. Few lenders will allow you to access all of your home equity. Only the VA allows 100 percent cash-out refinancing.
For cash-out refinancing, most private lender guidelines (Fannie Mae, for example), max you out at 80 percent. FHA gives you up to 85 percent of your property value.
Most home equity loans go a little higher — to 90 percent if your credit history is excellent, and if your income supports the higher payments.
When you add a so-called “second mortgage” to your current mortgage, your loan-to-value is often called CLTV, for Combined Loan to Value.
How to get equity out of your home: cash-out refinance
With a cash-out refinance, you get a whole new first mortgage. That new mortgage pays off your existing one and you get a check for the balance, less whatever equity you or your lender decide must remain in the home.
Cash-out refinances rarely make good financial sense unless you get a better rate than the one you’re currently paying. And that’s unlikely at the time of writing because of recent rises in mortgage rates. It’s made even less likely because of risk-based lending (a.k.a. “loan-level pricing adjustments), which typically imposes a slightly higher rate on cash-out refinances than other ones.
However, there are times when you absolutely need cash. You might need to consolidate out-of-control debts or pay for something essential, such as medical bills. In those circumstances, the extra costs may be worth it.
Cash-out refinancing pros
Even with risk-based lending, this may well turn out to be the lowest rate you can find. It’s also likely to come with the lowest monthly payments, simply because you’re typically spreading those over the next 30 years.
Cash-out refinancing is one of the most popular, if not the most popular, for financing home improvements.
Cash-out refinancing, if you can better terms than you have on your current loan, can make sense, especially if the amount you are borrowing is large and the balance of your current mortgage is small.
So there’s a good chance a cash-out refinance will be the kindest to your household budget.
Cash-out refinancing cons
There are three main drawbacks:
- You’ll face high set-up costs, which make borrowing small sums of money expensive. That’s because the extra charges for a cash-out apply to the entire loan, not just the extra cash
- You’re resetting the clock on your mortgage. Instead of paying for your home in 30 years (assuming that you refinance from one 30-year loan to another), you’ll be adding 30 years to your repayment
- That means your overall cost of borrowing will be high. Even low rates can’t typically make up for the additional costs of loans that last significantly longer
You can refinance to a shorter term, like 15 years, which gets you a lower rate and faster repayment — as long as you can afford the higher payment.
How to get equity out of your home: FHA 203(k) refinance
This is only going to work if you’re using all the money from your refinance for home improvements. And it’s a government program, so you have to refinance your primary home and the improvements can’t be too fancy. You can see a long list of eligible works on the HUD website.
FHA 203(k) Pros
The program is great if you’re not in a strong financial position because:
- The program offers more flexible underwriting and allows lower credit scores
- FHA 203(k) loans max out at higher LTVs (97.75 percent according to this handy checklist from HUD)
- Can base your home’s value on what it will be worth after you’ve finished the improvements
- Offers competitive mortgage rates, though not the lowest
All these pros come with a big con. You’ll have to pay FHA mortgage insurance premiums throughout the term of your loan.
How to get equity out of your home: home equity loan
Home equity loans (HELs) are also called second mortgages. With one of these, you leave your existing mortgage in place and have a separate loan to meet your current needs.
HELs can be especially attractive during periods when mortgage rates are rising. Why pay a higher rate on all your borrowing when you can keep your low rate on your first mortgage and pay a higher one just on your new loan?
Home equity loan pros
- Rates are often just a bit higher those of a cash-out refinance
- LTVs for your combined secured loans are similar to those for a standard refinance: 80 percent for most; 90 percent for the most qualified borrowers
- Most HELs come with fixed rates and terms so they’re protected against inflation, and are highly predictable for budgeting
No wonder HELs are popular.
Home equity loan cons
- Closing costs are comparable to refinancing a first mortgage. Expect appraisal fees and title insurance premiums — and often lender’s origination fees
- Your rate will almost certainly be higher than on your first mortgage, though lower than with other forms of borrowing
- It’s still a secured loan. So you’re putting your home on the line if things go wrong
How to get equity out of your home: HELOC
A home equity line of credit (HELOC) is the love child of a home equity loan and a credit card. It is not open-ended like a credit card, however; eventually, you have to pay it off in full.
Your lender determines your credit limit (usually somewhere between 80 and 90 percent), and you can borrow up to that. During the initial phase (called the drawing phase), your payment is simply the interest on the amount of credit you are using. For a 15-year HELOC, the drawing phase may be five years. You can use and reuse your credit just like you can a credit card.
HELOCs offer some unique advantages for those who don’t need a lot of money upfront, and who are happy with their current mortgages.
- Home equity lines of credit usually have very low setup costs — even zero in some cases
- You only pay interest on the amount you actually use
- It’s great when you don’t know exactly how much you need, or when you’ll need money for an ongoing project
- HELOCs make nice emergency funds because you only pay interest if you use them
- Budgeting can be difficult because HELOC rates are almost always variable. However, some allow you to choose a fixed rate and payment once you exit the drawing phase
- When your drawing phase ends, you have to repay the loan. And while you may have started with a 15-year loan and a low interest-only payment, you will now be looking at a 15-year loan with ten years left to repay it, and interest rates that may be going up
For instance, if you borrow $20,000 at 4.5 percent with a 15-year HELOC and a five year drawing period, and your balance increased by $4,000 every year and your rate increased every year by 1 percent, here’s your possible payment schedule:
- Year 1: Balance: $4,000 Rate: 4.5 percent Payment: $15
- Year 2: Balance $8,000 Rate 5.5 percent Payment: $37
- Year 3: Balance $12,000 Rate: 6.5 percent Payment: $65
- Year 4: Balance $16,000 Rate 7.5 percent Payment: $100
- Year 5: Balance $20,000 Rate 8.5 percent Payment: $142
YEARS 6 THROUGH 15: PAYMENT (assuming you can fix your rate at 8.5 percent): $248 MONTHLY
Of course, some people will get themselves into trouble no matter how they borrow. But with loans that are secured by your home, it’s especially important you get everything right — including the rate you pay. So be sure to shop around for the best deal on the type of loan that’s most appropriate for your individual needs.