Is It Bad to Take Equity Out of Your House?

Understanding the Risks: Should You Take Equity Out of Your House?

When people need money for a home improvement, a large purchase, or an emergency, a home equity loan can be an appealing option. However, there are risks in borrowing money using the equity in your home. If you’re able to pay the loan, though, it can be a useful source of supplementary income.

‍There are several options if you want to borrow money using the equity in your home. There’s a standard home equity loan, a home equity line of credit (HELOC), and a cash-out refinance. Each of these loan types can be used on anything the homeowner sees fit. However, each loan type works differently. Make sure to do your research before using any of them.‍

What Is Home Equity?

Home equity is calculated based on the current market value of your home, less any mortgage balances. You gain home equity through the portion of your monthly payments that reduces your principal loan balance. At the time of purchase, your down payment also creates some equity in your home.‍

The longer you’ve been making monthly mortgage payments, the more equity you have in your home. The higher your equity, the more you can borrow from a lender through a home equity loan.

‍Home equity is a clear way individuals can build up generational wealth. However, one has to own a property or be in the process of paying off a mortgage to build equity. If someone rents a home or apartment, they make monthly payments to rent their property, but none of their rent goes towards owning it. One also pays a monthly payment on a mortgage loan, but a portion of these payments go towards accumulating equity and eventually owning the property.

‍Depending on one’s mortgage terms, part of one’s monthly payments goes towards interest, and the other goes toward the principal loan balance. The portion of the monthly mortgage payment that is applied to reduce the principal loan balance builds home equity.‍

How Home Equity Works

As one owns more property, they’re building wealth. Home equity loans are a way to borrow against this wealth. These loans allow homeowners to access the equity they created by reducing the principal balance of the mortgage without selling their property. 

‍Obtaining a home equity loan is similar to qualifying for a traditional mortgage. You’ll need to apply to a bank, online lender, credit union, or other company to get approved for this type of loan.

‍The approval process looks different depending on which bank or institution you use. However, most lenders will look at a similar set of criteria when examining an applicant.

‍Lenders evaluate an applicant’s credit score, debt-to-income ratio (DTI), income, loan-to-value ratio (LTV), and past credit history. Furthermore, a lender may use an appraiser to calculate the current market value of a home or property. This information helps the lender determine if an applicant will qualify for a home equity loan.‍

Why Should I Use Home Equity?

Borrowing against one’s home equity can be a quick way to secure large amounts of money. Furthermore, home equity loans generally have lower interest rates than other personal loans. These loans can help fund a home improvement project, respond to an emergency, or increase one’s cash flow.‍

Best Ways to Access Home Equity

The best way to access your home equity will depend on what you want to do with the money. Certain circumstances will favor different types of home equity loans. Consider the following loan types to determine which one works best for you.‍

Home Equity Loan

A traditional home equity loan is a second mortgage, delivered as a lump sum at loan closing, and repaid over a set time. Payments on a home equity loan are similar to a traditional mortgage. Monthly payments are comprised of interest and principal reduction. The interest assessed on the home equity loan is the interest rate for the mortgage loan. The interest rate on the home equity loan has a direct impact on the amount of the monthly mortgage payment (i.e., the higher the interest rate, the higher the monthly mortgage payment).‍

The traditional home equity loan is structured similarly to one’s primary or first mortgage. ‍

Home Equity Line of Credit (HELOC)‍

A home equity line of credit (HELOC) is a popular choice for home equity loans because of its flexibility. This type of loan is often a second mortgage but may also be a first mortgage on the property. Unlike a traditional home equity loan, it has a revolving line of credit limit that works similarly to a credit card during the draw period of the HELOC. A homeowner only borrows what they need to and then pays it back.  However, in a HELOC, the interest rates are typically much lower than a credit card.‍

In this loan type, the amount you have to pay is determined by how much you use rather than how much is available to use. Sometimes, HELOCs will come with a debit card to make it easier to access your line of credit.  HELOCs are typically adjustable-rate mortgages, meaning the interest rate will adjust during the life of the loan.

‍A HELOC has two phases: a draw period and a repayment period. During the draw period, one can withdraw funds up to the full line of credit. This period can last many years.

‍After the HELOC draw period ends, one enters a repayment period. In a repayment period, the balance on the HELOC then has monthly payments to reduce the balance outstanding, but no further draws can be made after the end of the draw period. The repayment period will often have a fixed time to pay back the loan. For example, a popular HELOC product has a 30-year term comprised of a 10-year draw period and then a following 20-year repayment period.  The outstanding balance on the HELOC will be paid in full during the 20-year repayment period but can always be paid off sooner.‍

Cash-out Refinance

In a cash-out refinance, you don’t take out a second loan. Instead, you refinance the first mortgage on your home and cash out the equity in the home up to the maximum loan-to-value allowed by the lender. This method only works if you have available equity in the home, either through an appreciation in market value or a reduction in the first mortgage balance. Keep in mind that the closing costs on cash-out refinance tend to be high. Still, cash-out refinancing can be a quick way to gain extra money.‍

Things to Consider Before Taking Out Equity

It can seem like a no-brainer for many to take out a home equity loan. However, there are particular dynamics to be aware of before taking out one of these loans. Consider the following factors, and you’ll better navigate getting a home equity loan.‍

Home Value Can Decrease

In certain situations, the value of one’s home may decrease. A decrease in home value can come from an economic downturn or severe home damage. You could owe more on your mortgage and home equity loan than your home is worth in these situations. It may seem like these things won’t happen to you. Still, they’ve happened to others in the past, so proceed with caution.

‍For instance, if you took out a $300,000 mortgage on your home but then housing prices drastically dipped in your area, you could end up owing more on your mortgage than your home is worth. When this happens, it’s called being underwater in your home. If you’re underwater on your home, your approval odds decrease on future financing possibilities because of the lack of or little equity in your home. The same dynamic occurs with home equity loans. If the value of your home decreases, you still owe the lender whatever you withdrew through the line of credit.

Borrowing Limitations

Most lenders will set a limit on how much a homeowner can borrow through a home equity loan or HELOC. The calculation lenders use to determine how much you’re eligible to borrow is your loan-to-value ratio (LTV).

Lenders will often let people borrow up to 80 percent of their home value minus whatever their current loan balance is. Eighty percent is just a general limit. Specific limits will depend on the lender’s guidelines and the borrower’s unique financial situation.

Have a Use Plan

One of the worst things someone can spend their home’s equity on is an unnecessary personal or recreational expense – such as a new car or an extravagant vacation. Since these loans are an easy way to tap into a large store of wealth for many homeowners, it’s tempting to use them for unneeded purchases. Furthermore, many people may not plan to use their home equity loans for personal purchases but then waver once they have the loan.

‍For this reason, it’s critical to have a spending plan before taking out any type of home equity loan. It will require discipline to stick to your spending plan once you’re approved for a loan or line of credit. A spending plan may prevent you from purchasing things you don’t need.

Remember, if you default on a home equity loan, you could lose your home—all the more reason to take these loans seriously.

Top 5 Reasons for Using Home Equity

Many people make standard purchases with home equity loans. Consider the following list of common home equity loan purchases to help determine if this loan type is right for you.‍

Home Improvements

A typical application for home equity loans is home improvement. Generally, this is a beneficial way to use a home equity loan. Not only does it increase one’s standard of living, but it could also raise the value of one’s home. Because certain home improvements may raise a home’s market value, they’ll often pay for themselves over the long run.‍

Emergency Funds

Many people are unable to save much money, which becomes a challenge when an emergency occurs. People need to stay afloat when unexpected life circumstances arise, such as a medical crisis. Securing a home equity loan can be helpful for people in these circumstances if they don’t have a large amount of savings.‍

However, keep in mind using a home equity loan to cover emergency expenses could be a quick way to amass large amounts of debt. A better way to navigate life’s emergencies is to start investing in an emergency fund. That way, you won’t have to borrow money if an emergency occurs.‍

Debt Consolidation

A HELOC can be helpful if someone is trying to consolidate their debt. Since HELOCs typically have lower interest rates than unsecured personal loans or credit cards, homeowners can use them to pay off any form of debt with a higher interest rate.

‍It may seem like a strange idea to take out a loan to pay other debts. However, if the new loan has a better interest rate than the different forms of debt, this could stand to save you money.‍

College Funds

Many people have student loan debt. If the interest rates are better, it can be advantageous to use a HELOC to pay for college expenses or a student loan. Furthermore, some parents may use a HELOC to fund their children’s college education if they don’t want their children to go into debt or the terms are better on the HELOC than a student loan.

Wedding Expenses

Weddings are a considerable expense. If a couple can use a HELOC to pay for their wedding, it may be the preferred way to fund the event. Often, couples may turn to personal loans or specialized wedding loans to pay for their special day. However, if the terms or interest rates are better on a HELOC, it may make sense to use this loan type over others.‍

Bottom Line

Despite the advantages of using home equity loans over other loan types, defaulting on a home equity loan may cost you your home. Remember this consequence before using a home equity loan or a HELOC.  Because the stakes are high, only use a home equity loan or a HELOC if you are confident you can pay back the loan. There is no reason to lose your home if other loan options are available to you.

‍For more information on what loan options are available to you, contact a Wesley Mortgage representative today!