You’ve probably heard it said that most Americans don’t hold their wealth in their bank accounts or stock portfolios; their wealth is in their home equity. Is this the case with your situation? Not having your money in cash can leave you feeling like your theoretical net worth doesn’t match your real net worth. The good news is that, even though your home equity isn’t in your bank account, you still have access to it.
So, what is home equity? More to the point, how can you access your equity? Well, you have several options, such as a home equity line of credit (HELOC) or a cash-out refinance. In this article, we’ll explain home equity and discuss whether you should go for a HELOC, a cash-out refinance or even something else entirely.
What is home equity?
Your home equity is the value of your home’s market value after subtracting any liens (or debts) someone else may have on your home—typically your mortgage. In plain English, your home equity is the value of the home that you own—the total value minus what you owe on your mortgage.
“But wait,” you might say, “I paid for my home, don’t I owe all of it?” While you are certainly the legal owner of your home, it gets a little more complicated when you appraise home equity. Unless you paid for your entire home in cash, you probably purchased your home with either all or some of the price being covered by a mortgage. This means that your bank or other lending institution has a financial interest in your home represented by a lien. Since you will owe this value no matter what and must pay it off, it counts as “negative” home equity.
The good news, though, is that as you pay off your mortgage, the lien amount decreases and your home equity increases.
How it works
It might seem a little complicated so let’s use an example:
Let’s say the home you’re purchasing is worth $250,000, and you are able to put $25,000 down as a down payment, paying the rest with a mortgage. On day one of your new life as a homeowner, you have home equity of $25,000—your down payment. That is, the one part of the home that you didn’t pay for with mortgage money.
In our scenario, you’ve opted for an aggressive and short-term mortgage period. So one year after purchasing your home, you have paid a further $25,000 toward the principal. This means that your home equity is now $50,000.
But wait! It turns out that your house is in an excellent, highly desirable area that’s quickly growing, and over the course of that same year, your home’s value has risen by $50,000. The lending institution has no claim to that extra value—only you do. This means your total home equity one year after purchasing your home is $100,000.
Once your finish paying off your mortgage entirely, your home equity will be $250,000 plus however much the appraisal price has risen due to home values increasing.
This value is something that you can borrow money against, such as with a home equity loan, HELOC or cash-out refinance.
Should you get a home equity loan, HELOC or cash-out refinance?
All three of these options generate some liquidity based on your home equity. However, they are all different and come with their own pros and cons. Let’s discuss which may be right for you.
Home equity loan
A home equity loan is a loan borrowed against the value of your home. This usually takes the form of a one-time, lump-sum loan, which you then pay off as you would any normal loan. Home equity loans usually have a maximum value based on your home’s value and the balance of your mortgage. This is called a combined loan-to-value (CLTV) ratio. In our example above, during your first year, you wouldn’t have many options since the CLTV ratio would be quite high. However, the more paid off on the mortgage, the more you could borrow against your home equity.
A home equity line of credit (HELOC) is similar, except instead of being a lump-sum, one-time loan, it’s a line of credit (with a similar maximum value calculated by CLTV) that you can draw from anytime, like a credit card. The lending institution might send you checks when you request them or give you a separate debit card.
Typically, a HELOC is divided into two parts: the draw phase, lasting a set amount of time (usually 10 years), and the repayment phase, lasting longer (usually 20 years). In the former, you can draw as much money as you want from your HELOC, up to the cap. In the latter, you can no longer draw money but must instead repay it.
The benefit of both a home equity loan and a HELOC is that since you’re using your home as collateral, you can usually get very low interest rates. The drawback is that you’re using your home as collateral, so if you can’t repay what you owe, you could risk your home—so make sure your finances can absorb the extra repayments.
A cash-out refinance is different from either of the above, though it is also a way to turn your home equity into liquidity. Fundamentally, it’s like any mortgage refinance—you take out a new mortgage and use it to pay off your first mortgage. Mortgage payments going forward will be made on the new home loan. Often, the new mortgage also has different terms, such as a lower interest rate or shorter repayment period. However, with a cash-out refinance, rather than borrowing the exact sum you owe on your mortgage, you borrow an additional sum of money—the difference of which is given to you in cash.
Like a home equity loan or HELOC, a cash-out refinance is an additional debt you owe beyond your mortgage. However, since it’s added to your mortgage, it may be easier to pay off rather than having multiple major debts to juggle. For this reason, it’s an excellent option for anyone seeking to borrow money against their home equity.Have any questions? Talk to a Home loan Guideat Solarity Credit Union today.