Tanza Loudenback
Homeownership is one of the largest sources of wealth for Americans. If your home’s value goes up and you pay the mortgage on time, your ownership share increases, turning it into a veritable piggy bank.
Thanks to the run up in home prices during the pandemic, U.S. homeowners have
access to more cash in their homes than ever before. At the beginning of 2022, the average homeowner had $207,000 in tappable equity, according to mortgage-data firm Black Knight.
Home equity loans are one way you can pull cash from your home. Here’s how the loans work, how to shop for one—and the risks of using one.
Home equity is the difference between the value of your home and the amount you owe on your mortgage. Typically your equity will go up each time you make a payment. If home values rise, you’ll get an extra boost. Picture an old-fashioned scale—when you first buy a home, you probably have more debt than equity, so the scale is lopsided toward debt. But each mortgage payment adds weight to the equity bucket, tipping the scale over time.
Home equity loans, also called second mortgages, are an alternative to using credit cards or personal loans to consolidate debt, fund a large purchase or handle a financial emergency. You’re still taking on debt, but often at a lower interest rate than those other methods. That’s in large part because the loan is secured by your home, which the bank can take if you fail to repay what you owe. With credit cards, the consequences— including reduced credit access, late fees, and mounting interest—aren’t as severe.
If you’re approved for a home equity loan, you get a lump sum that you can spend however you want. Then you’re responsible for monthly payments of principal and interest, in addition to your primary mortgage payments.
In a rising housing market, says Eric Alexander, a financial advisor at Benchmark Income Group in Dallas, the value of your home will continue to rise as you pay yourself back. “Your house has no idea there’s a loan against it,” he says—meaning the loan won’t affect your ability to build wealth. “That, to me, is a positive.”
But how much cash can you get out of your home? First you need to find out how much equity you have.
You need an appraisal to qualify for a home equity loan, but you don’t have to go out and spend $500 to $750 hiring an appraiser yourself, says Robert Heck, vice president of mortgage at Morty, an online mortgage broker. Most lenders will want to do an appraisal in-house, he says, so that step will probably come after you’ve selected a lender.
If you want an estimate of how much your house is worth before applying for a home equity loan, use free online tools from real estate marketplaces like Zillow or Redfin, or check if your primary mortgage lender can help. “Some lenders actually have these systems available to consumers early on in the process,” Heck says. “And they may not charge for it.”
Say your current home value is $500,000 and your remaining mortgage balance is $200,000. The portion of the home you outright own—your equity—is $300,000. Put another way, you have 60% equity; the other 40% is owned by the financial firm that holds your mortgage.
Lenders typically require home equity loan borrowers to maintain at least 20% equity. That means you can borrow up to 80% of your current home value between your existing mortgage balance and your new loan. Here’s the formula, using the numbers from the example above:
But, how much you technically can borrow isn’t always the same amount your lender will approve. “It’s very, very much dependent upon your borrowing profile, as well as how much equity you have in the home relative to any mortgage or additional financing you might already have,” Heck says.
You usually need to have a good to excellent credit score (that’s 670 or higher) and a low debt-to-income ratio to qualify for the maximum loan and the lowest possible interest rate. Average rates on home equity loans in September 2022 were between 6.39% and 8.07%, while the average rate for fixed-rate, 30-year first mortgage was just under 6%.
Your debt-to-income ratio is calculated by tallying up all of your monthly debt payments, including mortgages and any other personal debts, and dividing that by your monthly income. For example, monthly debt payments of $1,200 and monthly income of $5,000 equals a debt-to-income ratio of 24%. The highest ratio most lenders will accept for home equity loan borrowers is 43%.
A home equity loan and a home equity line of credit, or HELOC, are both types of second mortgage—ways to leverage the wealth you’ve built in your home to get access to cash.
In both cases, you need an appraisal of your home to determine its value, and a lender will evaluate your credit score and other financials to decide how much you can get.
You’ll need to repay what you borrow from either a home equity loan or a HELOC, but the timing and size of the loan and repayments differ. A HELOC is similar to a credit card, Heck says. You have access to cash for a preset amount of time known as the draw period, which is usually 10 years. You’ll have to make interest-only payments during that time, and rates are variable. When the draw period is up (or earlier if you want), you start repaying what you borrowed, with interest. The repayment period for a home equity loan begins immediately after you get the cash.
Deciding which type is best for you often comes down to matching repayments with cash flow, Alexander says. If you have consistent income, a home equity loan is often a better choice, since payments are fixed. If you have inconsistent income, say you work on commissions, for example, then the repayment flexibility of a HELOC looks more attractive, he says. Interest rates are similar on both types of loans, although HELOCs with variable, or adjustable, rates can be lower for the first few years of repayment.
While the mortgage you get when you first buy a house can include exorbitant closing costs, home equity loans and HELOCs typically don’t include those fees. “If they’re not free, they are usually fairly inexpensive,” says Alexander.
Another tool for tapping home equity is a cash-out refinance. This method requires taking out a new loan that’s larger than your existing mortgage balance so that you can pay off the debt and pocket some cash. Your new mortgage will have a lower interest rate, too, which may lower your monthly payment.
Heck says many of these home equity strategies had largely been “shunned” since the 2008 financial crisis, a moment spurred by homeowners pulling out too much home equity.
But since the pandemic transformed the housing market, Heck says, “we’re in one of the first sort of rate and home-price environments where these products actually might be the best option for consumers” who want to access credit at a relatively low cost.
A danger of home equity loans or HELOCs, of course, is that your home is on the line. Lenders can start the foreclosure process after just three months of missed payments.
Scott Fligel, a financial planner with Northwestern Mutual based in Charlotte, N.C., says he most often sees clients using home equity loans for large purchases, such as renovating a kitchen or building a pool.
“When things are volatile and [people] see investments going up and down,” Fligel says, “it may feel good to invest in their home thinking that that will be the best long-term return.” Whether that plan bears fruit depends on the individual’s ability to repay the loan and, ultimately, how well the decision aligns with their overall goals, he says. Improving your living space is one thing, but it’s unwise to assume every renovation is a value-add. Data from Remodeling Magazine shows that typical homeowners recoup only about half of the cost of a bathroom remodel.
Another common use for home equity loans, Fligel says, is consolidating debt. Homeowners can use the cash to knock out high-interest debt on credit cards and then repay their home equity loan at a more manageable rate.
“Those are really great uses,” Alexander says. “Where I don’t really recommend either the home equity loan or home equity line of credit is what I would call the ‘fliers,’” or speculative investments. If you spend borrowed funds on a hot stock tip that doesn’t pan out, for example, “now you’ve lost the investment and you’ve gotta go repay the loan,” he says.
When you apply for a home equity loan or a HELOC, the lender assigns an interest rate to your loan after evaluating your financial profile.
“Typically speaking,” Heck says, rates on HELOCs and home equity loans are slightly higher than primary mortgage rates because the new lender is taking on more risk.
Still, he emphasizes the importance of casting a wide net. “I definitely think that there’s a lot of opportunity to shop, to get lower interest rates that are gonna actually be closer to what you would find on a primary mortgage from some providers,” he says.
Aim to explore loan options and get quotes from at least four to five lenders, Heck says, including a credit union, a traditional bank, your existing mortgage lender and an online lender. “Get a sense for the range of offerings across all these different types of lenders, because at the end of the day, they all have different specialties that they focus on,” Heck says.
If the majority of your financial accounts are under one bank’s roof, then Alexander recommends looking at that firm’s loan options first. “They’re an interested third party hoping to expand the relationship,” he says. “They’re very motivated to help you have a good experience.”
Be sure to ask any lender about how the home equity loan is structured, Alexander says. In some cases, you may be able to switch from a fixed to variable rate, or vice versa, during the repayment period. And find out what fees apply, if any, to take out the loan and the timeline for getting the cash.
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