The past year has made clear just how valuable a home of your own can be — not just in emotional value, but in financial value as well. Average home prices across the country increased by 18.3% between June 2021 and June 2022, according to a report by data analytics firm CoreLogic.
Homeowners who bought before the pandemic housing boom are likely sitting on a piggy bank of home equity right now. And they can tap into that equity to fund money moves like paying for college, funding home improvements, or consolidating high-interest debt.
When used correctly, a home equity loan, home equity line of credit (HELOC), or cash-out refinance can be a good way to access large amounts of money at relatively low interest rates by borrowing against the value of your home’s equity. However, there are some risks and caveats to be aware of.
Here’s how each option works and what you need to know about getting equity out of your house.
Best Ways to Take Equity Out of Your Home
When you “take equity” out of your home, what you’re really doing is taking out a loan that borrows against the value of your home equity. In doing so, you’ll receive cash upfront but have to pay that money back with regular payments later on. And, because you’re adding to the total balance of loans secured by your home, the amount of equity you have in your home will decrease.
The three most common ways to take equity out of your home are home equity loans, home equity lines of credit (HELOCs), and cash-out refinancing. Each one works differently and has its own pros, cons, and best use cases.
|Home Equity Loan||HELOC||Cash-Out Refinance|
|What is it?||An installment loan secured by the value of your home equity, with a fixed interest rate and fixed monthly payments over a predetermined period of time||A variable-rate revolving line of credit secured by your home equity, where you can continuously withdraw money during the draw period and pay back what you borrowed during the repayment period afterward||A mortgage refinance that replaces your current primary mortgage with a new, larger one, and lets you keep the difference as cash|
|How do you receive the money?||In a lump sum when you take out the loan||You can continuously borrow money whenever you want, as much as you want (up to the credit limit) during the draw period||In a lump sum when you take out the loan|
|How do you pay the money back?||A separate, fixed monthly payment in addition to your primary mortgage payment||A separate, variable monthly payment in addition to your primary mortgage payment||Included in your monthly mortgage payment|
|Fixed or variable interest rate?||Home equity loan rates are fixed, meaning you lock in a rate at the beginning that applies for the duration of the loan.||HELOC rates are variable, meaning your rate will be determined based on the prime rate plus a margin. The prime rate can fluctuate based on market conditions.||Cash-out refinance rates are fixed. Because cash-out refinancing replaces your primary mortgage with a new one, the interest rate will apply to your entire mortgage, not just the extra money you’re borrowing.|
|When should you get it?||If you need a large, lump sum of cash all at once and want a fixed interest rate and fixed monthly payment||If you want access to an ongoing line of credit and you’re comfortable with a variable interest rate and variable monthly payment that could potentially increase later on||If you’re planning to refinance anyways, or you can get a lower refinance rate than your current mortgage interest rate|
HELOC vs. Home Equity Loan vs. Cash-Out Refinance
Home equity loans, HELOCs, and cash-out refinancing all let you turn your home equity into cash, but they each work in different ways.
What is a home equity loan?
A home equity loan is a loan against the value of your home, paid to you in a lump sum. In this sense, it’s similar to a mortgage that you will have to repay in installments, with principal and interest. In fact, a home equity loan is commonly referred to as a second mortgage for this reason. Unlike a cash-out refinance, taking out a home equity loan will not affect your primary mortgage.
Home equity loans have fixed interest rates and fixed monthly payments. You’ll often have a few different loan terms to choose from, typically ranging from five to 30 years. How much you can borrow depends on the lender, but generally you can get a loan for up to 80% to 85% of your home value, minus your primary mortgage balance.
Don’t accept the first offer you get — shop around with different lenders to get the best rate.
What is a home equity line of credit (HELOC)?
A home equity line of credit, or HELOC, is a revolving line of credit secured by your home that works similarly to a credit card. If you have a $30,000 HELOC and draw $10,000 to pay for a kitchen renovation, you’ll still have $20,000 left to use at a later time — or not. You’ll only pay interest on the amount you use, not the entire credit line.
HELOCs are divided into a draw period and a repayment period. The draw period is the time during which you can tap into the credit line, and typically lasts between 10 and 15 years. Depending on your lender, you may only need to make interest-only payments during the draw period. During the repayment period, which typically lasts 15 to 20 years, you’ll no longer be able to borrow money and must pay back the principal and interest on what you’ve drawn.
HELOCs have variable interest rates that fluctuate based on the prime rate, which means that your interest rate and monthly payment could increase later on if market interest rates change. Some home equity lenders may allow you to “lock in” a fixed interest rate on part or all of your HELOC, but doing so may come with a fee.
What is a cash-out refinance?
A cash-out refinance replaces your current mortgage with a new loan that is larger. You’ll get the difference in cash to use however you please. For example, if you have $100,000 left on your mortgage and you do a cash-out refinance of $150,000, you’ll get $50,000 in cash (minus any fees and closing costs). Often, people use cash-out refinances for home improvements, debt consolidation, or other large one-time expenses.
Since you’re refinancing, you’ll also get a new interest rate and a new loan term. This likely means you’ll extend your mortgage repayment term unless you refinance to a shorter term. If you can get a lower interest rate with a cash-out refinance, you could lower your monthly payment and reduce your overall interest costs.
However, mortgage interest rates are currently at all-time highs. If market mortgage rates are higher than your current mortgage rate — a likely scenario for homeowners who bought or refinanced during the low rate environment of 2020 and 2021 — a cash-out refinance is typically not a good move and could cost you more in the long run.
How Much Can You Borrow Against Your Home’s Equity?
To get approved for a home equity loan or a HELOC, you’ll need to show you have sufficient equity in your home. Most lenders will require that after the loan or HELOC is issued, you still have at least 15% to 20% equity in your home, says Elliot Pepper, CPA, CFP and co-founder of Northbrook Financial.
This means you may be able to borrow up to 80% to 85% of the appraised value of your home, minus the amount you owe on your first mortgage. In other words, your maximum combined loan-to-value ratio (CLTV) — the sum of all the debts secured by your house divided by your home’s value — cannot exceed 80% to 85%. Some lenders will allow a maximum CLTV of up to 90%, but that usually comes with a higher interest rate or stricter borrower requirements.
With a cash-out refinance, lenders will usually require you to keep at least 20% equity in your home, for a maximum loan-to-value ratio of 80%. This means the total amount of your new mortgage cannot exceed 80% of your home’s value. The actual amount of money you can take away from a cash-out refinance is your new loan minus your current mortgage balance.
For example, if you owned a home worth $300,000 and owed $150,000 on your mortgage, here’s how much you could borrow with a home equity loan, a HELOC, and a cash-out refinance:
|HOME VALUE||AMOUNT OWED ON MORTGAGE||MAX AMOUNT TO BORROW|
|Home Equity Loan||$300,000||$150,000||$90,000 (80% CLTV) to $105,000 (85% CLTV)|
|Home Equity Line of Credit||$300,000||$150,000||$90,000 (80% CLTV) to $105,000 (85% CLTV)|
|Cash-Out Refinance||$300,000||$150,000||$90,000 (80% CLTV)|
Of course, just because you might be eligible for the maximum amount doesn’t mean you have to sign for that amount — you should only borrow as much money as you need and can afford to pay back.
What is LTV (loan to value ratio)?
The loan-to-value ratio, or LTV, is one way to measure how much equity you have in your home. You can calculate your loan-to-value ratio by dividing your outstanding mortgage balance by the appraised value of your property.
The combined loan-to-value ratio, or CLTV, is the same idea, except you divide the combined balance of all outstanding debts secured by your home — including your primary mortgage and any home equity loans or HELOCs — by your home’s appraised value.
Most home equity lenders set caps on CLTV to make sure you’re not borrowing more than your home is worth. All other factors being equal, having a lower CLTV can lead to a lower interest rate on a home equity loan or HELOC because it presents less risk to the lender.
How to Get a HELOC or Home Equity Loan
Here’s our step-by-step guide to getting a HELOC or home equity loan:
- Decide if a HELOC or home equity loan is right for you. While you can technically get a home equity loan or a HELOC as soon as you own a home, it typically takes some time to build up the necessary equity. If you’re considering one, the best time to do so is when you have little or no consumer debt, stable employment, and good credit, with a score of 720 or higher for the best interest rate, says Lindsay Martinez, owner and financial planner of Xennial Planning LLC, a financial planning firm. You should also consider whether your financing needs are truly necessary to justify taking on debt. “You should not take a home equity loan for personal expenses such as a boat or fancy vacation,” Martinez previously told us.
- Research lenders and compare rates. “Most large banks and financial institutions offer home equity loans, so it’s always a good idea to solicit a few quotes and compare the terms, especially the interest rate and other fees, to make sure you get the right loan for you,” Pepper previously told us. Check out your local bank or credit union as well as online lenders.
- Choose a lender and complete an application. Once you’ve chosen a lender that fits your needs, you’ll need to complete the full application process. You’ll answer questions about your home and your financial situation. Be prepared to share your yearly income, how much you have left to pay on your mortgage loan, and the amount and type of any other debt you have.
- Get a home appraisal (if necessary). Some lenders will require you to get a home appraisal, or will at least strongly recommend it. This helps protect them in the event that you default on the loan and they repossess and sell your property to help pay off your debt. If your home isn’t worth as much as the lender originally assessed, they may sue you personally rather than foreclosing. This can result in garnished wages, tapping into your bank accounts or investments, or the repossession of other property.
- Complete the underwriting process and provide the necessary documentation. The underwriting process for a HELOC or home equity loan will be similar to the one you went through when you took out your first mortgage. You’ll need to show proof of income, proof that you own the property, proof of any debt you’re paying off, and any other financial documents your lender requires.
- Wait for your application to be approved and for your loan or line to fund. Your wait time will vary depending on the lender you choose, but you’ll likely have to wait a few weeks to a few months until your loan is approved. Then, you’ll sign the final loan agreement, pay any closing costs, and receive your money.
Pros and Cons of Tapping into Your Home’s Equity
Tapping into your home equity can let you access large amounts of cash at relatively low interest rates, but it’s not without its risks and drawbacks. Here’s what to know about the pros and cons:
Typically lower interest rates than personal loans or credit cards
Access to large loan amounts (as long as you have sufficient home equity)
Long repayment periods
Secured loans may be easier to qualify for than unsecured loans, since they’re less risky for the lender
Interest may be tax-deductible if you use the funds for qualified home improvements and meet other eligibility criteria
Loan is secured by your house, meaning you could lose your home if you default
You may not be able to borrow much money if you haven’t built up enough equity in your home
Longer, more extensive application and underwriting process than personal loans or credit cards
May come with upfront fees and closing costs
Requirements to Borrow Against Your Home Equity
If you’ve decided that borrowing against your home’s equity makes sense for you, it’s time to get your documents in order. Before you go to your bank or credit union and ask for a home equity loan or line of credit, here’s what you should have on hand:
- Personal information about you and any co-borrowers, including your Social Security number, date of birth, marital status, and residential status
- Information about your home, including purchase price and date, property type, an estimate of your property value, and proof of home insurance
- Information about all your debts and payment obligations. This includes mortgages on the property, car loans and student loans, and credit card debt
- Employment status and current income, along with proof of employment and income
To have the best chance of getting a loan at a low interest rate, make sure you have a credit score above 620 (or 720 to get the best interest rate) and that your debt-to-income ratio is 43% or lower. This may mean having to wait until you’ve boosted your credit score or reduced your debt relative to your income. Making early payments on credit card balances is one way to help your score rise in the short term, for example.
How to Increase Your Equity in Your Home
Your home equity will naturally increase over time as you pay down your mortgage or your house increases in value. To give yourself a little push, make the following moves to help your home equity rise:
- Make mortgage payments: Each time you make a mortgage loan payment, you’re creating equity in your home. That’s because you’re paying down what you owe to the bank and increasing the portion of your home that you own outright. If you want to raise your equity more quickly, making additional payments, whether recurring or one-time, can help.
- Increase the value of your home through home improvements: Certain home improvements will raise the value of your home, which increases your equity as well. Kitchen remodels, for example, tend to add to your home’s value since many buyers want new appliances and extras like granite countertops or kick lights. Creating more habitable outdoor spaces and updating bathrooms also can help increase your home’s value, since these are two other things buyers value highly.
- Wait for the value of your home to increase: Houses tend to appreciate slowly over time, but the housing market also experiences periodic booms. During these times, home values can increase almost overnight. For example, housing values hit all-time highs in 2020 and 2021. Many homeowners saw their home equity rise substantially just because there was a sudden increase in the demand for homes.
Alternatives to HELOCs and Home Equity Loans
While HELOCs or home equity loans can work for many homeowners who have equity in their home, not everyone will qualify for the best possible rates. Also, many borrowers aren’t comfortable taking on another loan secured by their home. Here are a few alternatives to consider if you need to borrow money:
- Cash-out refinancing: Cash-out refinancing allows you to refinance your mortgage for a larger one and pocket the difference. When interest rates are lower than your current mortgage rate, this can be a good option to access cash while simultaneously saving money on your mortgage. However, with mortgage rates skyrocketing, now may not be the best time to seek a cash-out refi.
- Personal loans: Personal loans operate exactly as they sound. You’re taking out a loan that you can use for nearly any personal reason. For those who want to avoid putting their home up as collateral, a personal loan can be a good alternative to a home equity loan or a HELOC, since many personal loans are unsecured. Also, personal loan funding can happen in just a few days, rather than a few weeks or months. However, interest rates tend to be higher than home equity loans or HELOCs, as the debt is unsecured.
- 0% APR or Balance transfer credit cards (for debt consolidation): If the main reason you’re looking to take out a loan is to consolidate other high-interest debt, balance transfer credit cards let you combine your debts onto one card that has a long 0% APR period. Balance transfer cards often offer 0% rates for anywhere between 12 to 18 months. Make sure you have a plan to pay the card’s balance off in that time frame, or you’ll be stuck with a high credit card APR.
- Savings: At the end of the day, if you don’t absolutely have to borrow money, it’s best not to. When you take out a loan, you have to pay interest, so you’re automatically paying back more than the amount you’re borrowing. You’ll also have to wait for funding and your credit score might take a hit. Pulling from savings lets you avoid paying unnecessary interest, and you won’t have to put any of your personal belongings up as collateral.