What is Home Equity and How Does It Work?

Do you dream of remodeling your outdated kitchen? Maybe you’re drowning in a sea of high-interest credit card debt and want to pay it off. Or perhaps you need money to send your child to college. You might just want the comfort of an emergency fund, so you’ll be prepared for any unexpected bills.
 
If you’re a homeowner, a home equity loan or line of credit might help you meet your goal. But before you sign on the dotted line, learn the basics of home equity so you’ll know if it’s the right choice for you.

What is home equity financing?

Home equity financing allows you to borrow money, using the equity in your home as collateral. You’re essentially converting the equity in your home into cash that you can use.
 
Lenders usually offer better interest rates for home equity financing than for other, unsecured types of personal loans. Typically, you can borrow an amount equal to 80 percent of the value of your equity. A home equity loan may be a good option for homeowners who need a large one-time payment for home renovations, for example, or to launch a small business.
 
There are different types of home equity financing. Some are loans, which you receive in one big payment. Others provide a line of credit, which you can access as needed, often using special checks or a credit card.
 
Home equity financing is secured by your home, so if you can’t keep up with your payments, you risk losing your home.
 
Home equity financing is different from mortgage refinancing, which involves taking out a new home mortgage loan to pay off your current one. If interest rates have fallen, traditional refinancing allows you to switch to a mortgage loan with a better rate. That can lower your monthly payment and may help you pay off your loan faster.

What is a home equity loan?

A home equity loan is a loan for a fixed amount of money that you repay over a fixed term.
 
This type of loan:

• is meant to cover large expenses rather than daily living expenses.
• provides the amount you borrow in a lump sum at the beginning of the loan’s term.
• carries a fixed interest rate. Your interest rate depends on factors like your credit score.
• requires equal monthly payments to repay the loan (including the interest) in full over the specified term.
• usually has a term of 5, 10, or 15 years.

 
A home equity loan is often called a second mortgage. Be aware that if you’re no longer able to pay your mortgages and your home is sold to pay them off, your original mortgage will be paid off first. Then your second mortgage gets paid. If this happens, there’s a chance that the sale won’t generate enough money to pay off your second mortgage. For this reason, lenders usually charge higher interest rates for second mortgages.
 

What is a home equity line of credit or HELOC?

A home equity line of credit is a type of second mortgage, so you’re borrowing against your home’s equity.

A HELOC:

• provides revolving credit, up to a certain limit.
• allows you to borrow money as you need it during the HELOC’s “draw period,” usually lasting 5 to 10 years. (This differs from a home equity loan, which provides a single lump payment.) You borrow money using special checks or a credit card.
• requires that you make monthly payments (that may vary) to pay the interest on withdrawals during the draw period. Many HELOCs have a variable interest rate that is capped. The rate is based on a publicly available economic index plus the lender’s margin. Other HELOCs have a fixed rate that won’t rise but tends to be higher than the rate of a variable-rate HELOC.
• must be repaid when the draw period ends, at which time you can no longer borrow. Some HELOC’s require a single balloon payment. Others let you repay the money you borrowed over several years.

What is a cash-out refinance?

A cash-out refinance offers homeowners another way to tap into their home’s equity to borrow money to cover a large expense.
 
It involves getting a new mortgage loan for more than you currently owe on your home. You use some of that loan to pay off (and replace) your existing mortgage (or mortgages). You receive the rest in cash.
 
To qualify, you must have an existing mortgage and equity in your home. You must also pass a creditworthiness check and submit a “cash-out” letter stating how you plan to use the loan.
 
A cash-out refinance:

• can help you pay off high-interest consumer debt more quickly if you can get a lower interest rate.
• may (or may not) lower your monthly mortgage payment. If you can get better terms than you currently have, your mortgage payment will shrink.
• may provide income tax benefits. If you use the money to upgrade your home, you can deduct the interest you paid on the loan portion of the refinance.
• may allow you to borrow up to 80% of your home’s value, although it varies. (Veterans Affairs mortgage loans let you borrow 100% of your home’s value.)

What is a reverse mortgage?

Older homeowners who need extra cash can use a reverse mortgage to borrow money, using their home’s equity as collateral.
 
To qualify, you usually need to be at least 62 years old, live in your home most of the time, have paid off most of your mortgage, and be free of any federal debt. To ensure that you make an educated decision, you need to attend a financial counseling session prior to getting a reverse mortgage.
 
If you’re approved for a reverse mortgage:

• you’ll receive payments from your lender—either a lump sum, monthly payments, or a combination.
• you may be able to spend the money on anything you like, or only certain things, depending on your reverse mortgage. With a federally insured Home Equity Conversion Mortgage (HECM), you can spend the money on anything. With a single-purpose reverse mortgage, the lender specifies how you can spend the money. You may need to spend it, for example, on home repairs.
• you must keep your home in good condition.
• the loan is tax-free.
• the money you receive won’t impact your Social Security or Medicare benefits.
• interest and fees are added to your loan balance each month. The costs may be higher than with other options—such as a home equity loan or a home equity line of credit—so make sure you understand the terms. On the upside, the interest you pay on a reverse mortgage loan is tax-deductible.
• you’ll continue paying property taxes and homeowners insurance on your home.
• the amount of equity you have decreases as you receive payments.
• the loan must be repaid if you (and any co-borrowers) move out or die. If you move or your home is no longer your primary residence, you need to repay the loan. If you move and one of your heirs wants to move into your home, the loan also needs to be repaid. If you die, your heirs either need to buy your home, sell it (to repay the reverse mortgage loan), or relinquish it to the lender.

While a reverse mortgage frees up cash, it also uses up your equity and increases your debt. So, if you eventually decide to sell your home, you may get very little—or nothing at all (depending on how much you borrowed).
 
Also, keep in mind that some reverse mortgage offers are scams. Check HUD’s Lender List to make sure your lender is honest.

How does home equity work?

Home equity is the amount of your home that you own right now. If you made a down payment on your home, that became equity. And with each monthly mortgage payment you make, your equity grows. When you increase your home’s value—by replacing the roof, for example, or renovating your kitchen—you also build equity.
 
Once you have enough equity in your home, lenders let you use your equity as collateral. You can borrow against your home’s equity to:

• make home improvements.
• purchase a vacation home.
• pay for your child’s college expenses (or your own).
• pay off high-interest consumer debt, such as credit card debt.
• start a business.
• pay off medical debt.
• cover emergency costs.

How much equity do I have in my home?

Your equity is the difference between your home’s current market value and the amount you still owe on your mortgage loan. You can use this handy Home Equity Calculator to see how much equity you currently have.
 
Here’s how the math works. To arrive at a solid number, you need to learn how much your home is worth. There are online calculators that provide an estimate, or you can contact a county assessor, who determines your area’s home values for tax purposes. Better yet, hire a licensed appraiser to visit your home and assess its value.
 
Next, check your latest mortgage loan statement to see your loan balance (the amount you still owe on your loan).
 
To determine your equity, lenders subtract your loan balance from your home’s appraised value. If your home’s value is $450,000 and you owe $300,000 on your mortgage, you have $150,000 in equity.
 
To calculate your equity percentage (the portion of your home that you’ve paid for), divide your equity amount by your home’s value. If you have $150,000 in equity and your home is worth $450,000, you’d divide 150,000 by 450,000 to arrive at 0.33. Then multiply that 0.33 by 100 to get a percentage—in this case, 33%. Your equity percentage is 33%. To qualify for a home equity loan, lenders generally want homeowners to have at least 15% to 20% equity.
 
You should also know your loan-to-value ratio. Simply divide your current mortgage loan balance by the appraised value of your home. If you owe $300,000 and your home is worth $450,000, you’d divide 300,000 by 450,000 to get 0.66. Then multiply 0.66 by 100 to get your loan-to-value ratio, which would be 66%. Most lenders prefer that your loan-to-value ratio be less than 80%.

Take (only) what you need

Avoid taking out a loan that’s larger than you need. If you do, you may be tempted to spend the extra money on luxuries. It’s not worth eroding the equity you have in your home for unnecessary treats.

What are the costs of a home equity loan or HELOC?

When you take out a home equity loan or HELOC, besides interest, you may pay:

• an application fee.
• a credit report fee to pull your credit report.
• an appraisal fee to determine your home’s market value.
• a title search fee.
• an origination fee to cover the underwriting and processing of your loan application.
• legal fees for preparing your loan’s legal documentation.
• a notary fee.

In total, closing costs typically range from 2% to 6% of the loan amount.

Is home equity financing interest tax-deductible?

The interest you pay on a home equity loan or a HELOC is deductible if you use the loan to improve your home. If you use the money to add a solar roof or renovate your bathroom, you can deduct the interest from your taxes. If you use it to pay off credit card debt, you cannot.

 

 
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