American homeowners are holding vast amounts of real estate equity – more than $30 trillion at the end of 2022 according to the Federal Reserve. That’s equity which can fund educations, start businesses, pay medical bills, and bulk-up cash reserves.
Sounds great, but how do you actually tap real estate equity without selling and moving? For most homeowners there are three basic ways to access real estate dollars: refinance the property, get a home equity line of credit (a HELOC), or take out a home equity loan. Each has pros and cons, so let’s see how they compare.
With a mortgage refinance you replace one or more existing loans with new financing. The reasons to refi include shifting to a lower mortgage rate, replacing an adjustable-rate loan with fixed-rate financing, ending the need for mortgage insurance, and – with so much equity now available – raising cash.
Whatever the goal, it’s important for borrowers to obtain what lenders call a “net tangible benefit” from their refi. In other words, you can always refinance but you want to make sure it’s a good deal for you.
For example, as of early 2023 mortgage rates were more than double what borrowers could pay in January 2021 when the mortgage marketplace hit record lows. This means “rate-and-term” refinancing – replacing an existing loan to get a lower-rate mortgage – is simply not attractive for many homeowners at this writing.
The situation with “cash-out” refinancing is different. With a cash-out refi we might have a home with $200,000 in existing mortgage debt and a fair market value of $500,000.
If a lender allows 80% refinancing, the borrower will be able to obtain $400,000 ($500,000 x 80%). Of this amount, $200,000 will be used to repay the existing loan balance and as much as $200,000 in cash will be available to the borrower, less closing costs.
A “cash-out” refinance might well make sense for a specific purpose such as starting a business, paying for college, or eliminating high-cost consumer debt. Mortgage rates, for example, are nowhere near the 20% interest levels routinely charged for credit cards.
And mortgage financing might be preferred when compared with student debt, a complex form of borrowing which in some cases can extend far beyond 30 years.
For instance, The Washington Post reported in February 2023 that nearly 47,000 people have had their student loans outstanding for at least 40 years and most long-term student loans – more than 80% – were in default.
However, many homeowners simply don’t want replacement mortgages because they were able to get historically-low home loans during the pandemic. They want to keep such financing in place and instead get a second loan in the form of a home equity loan or a home equity line of credit (HELOC).
Home Equity Loans
A home equity loan is simply an additional loan. The original mortgage stays in place.
If the existing financing has a fixed rate then it’s rate and monthly payment for principal and interest will remain unchanged.
Let’s look again at our model property with a $200,000 mortgage balance and a $500,000 fair market value. A borrower might get $200,000 in cash with a second loan if the lender will finance up to 80% of the property’s fair market value or $250,000 for 90% financing.
The big question with a home equity loan is one of affordability: Does the borrower have an acceptable debt-to-income ratio (DTI) and sufficient credit to support the desired financing? If the numbers look good a home equity mortgage application can fly through the system.
» MORE: See today’s refinance rates
Home Equity Lines of Credit (HELOCs)
A home equity line of credit (HELOC) is the real estate equivalent of a credit card. However, interest rates are much lower than credit cards because a HELOC is secured by real estate.
The HELOC’s rate, which is often adjustable, and the ability to repeatedly borrow and repay up to the credit limit makes such financing attractive.
A typical HELOC has two phases: in phase one, perhaps 10 years, the borrower may repeatedly use and pay down the credit line. At the end of phase one, the borrower no longer has the ability to take funds from the line.
If there’s an outstanding balance, the borrower must repay the debt during the HELOC’s second phase, perhaps another 10 or 15 years. The payments are made on a monthly basis.
If our $500,000 model home has a $200,000 mortgage balance, a $200,000 HELOC might be possible if a lender allows an 80% combined loan-to-value (LTV) ratio. ($500,000 x 80% equals $400,000.
If we subtract the $200,000 in existing debt from the $400,000, then the HELOC can be as much as $200,000.)
Which option is best for tapping your equity? There’s no single answer, but if you now have low-rate financing you’ll likely prefer to keep it and add a home equity loan or HELOC to pull cash from your property.