Good news for homeowners these days: thanks to housing values that are on the rise, they’re accruing record amounts of home equity. That means more spending power for people who might not otherwise have that capacity. But how, exactly, does home equity work and how can you tap into your existing equity? In this article, we’ll break down the answers to those questions and more.
How does home equity work?
Home equity is the difference between the fair market value of your home and what you owe on your mortgage.
For instance, if your home is worth $300,000 and you owe $200,000 on your mortgage, your equity would be $100,000. Two years down the line, your mortgage balance is now $180,000 and your home’s value has increased due to a favorable market to $310,000. You now have $130,000 in home equity.
Your home's equity can increase when:
- You pay off your mortgage
- You increase the value of your home through renovations or remodeling
- The value of your home increases due to favorable market conditions
In short, you gain equity when the amount you owe goes down and/or the value of the home increases.
However, you can also lose equity. Home equity can decrease when:
- You take out additional loans against the home, such as a home equity loan or a cash-out refinance
- Market conditions deteriorate
- The home loses value by becoming run-down or losing curb appeal
Essentially, equity decreases when your home loses value faster than the rate at which you are paying off the home.
How to Get Equity Out of Your Home
So you have equity in your house— how do you turn that into cash that you can put towards other things?
There are actually three main ways to take advantage of your home’s equity: with a home equity loan, a home equity line of credit, or a cash-out refinance.
Home Equity Loan
A home equity loan allows you to borrow money against the value of your home equity. The loan closely resembles that of a traditional home mortgage— you’ll be approved for a loan amount that will then be paid back monthly, with interest, over a set number of years.
Your home serves as collateral for the loan, which means better interest rates for borrowers. It also means, however, that if you default on the loan, you risk losing your house to the bank.
Home Equity Line of Credit
A home equity line of credit is similar to a home equity loan with one notable difference. Instead of receiving a one-time loan lump sum, you borrow from your financial institution in installments as you need it.
Think of it as a hybrid between a credit card and a traditional loan. When you establish a line of credit, you’ll be approved for a credit limit and a specified borrowing period. When you need money, you go to your lender and withdraw the amount you want.
You’ll only pay interest on what you borrow, which can save you thousands compared to a traditional home equity loan. HELOCs are especially helpful for things like home improvement projects since you often don’t know the exact costs of projects until you get to work. Instead of taking a huge sum of money upfront and paying interest on the entire amount, you’ll just take what you need in smaller increments.
There may come a time when you wish to take advantage of lower interest rates or change the terms of your mortgage. To do this, you’ll need to pay off your current mortgage with a new one that has the more desirable terms. This is called a home refinance.
A cash-out refinance is similar. However, instead of taking out a new loan in the amount of your current loan balance, you’ll take out a bigger mortgage. You’ll completely pay off your old one and take the difference in cash. This is a good option as long as you can get better terms on your new loan.
How much home equity can I borrow from my home?
How much you can borrow with these types of loans likely depends on the state you live in. For instance, Texas has some unique laws when it comes to using the equity in your home.
In Texas, you cannot use more than 80% of your home’s equity. Even if you own your house outright, you cannot take out a loan for the total fair market value of your home. The largest loan you can get is 80% of its value. So that means if your home’s value is $300,000, and you have 100% equity, the largest amount you can borrow is $240,000.
Similarly, if you have a balance on your mortgage, the combined balance and home equity loan cannot exceed 80% of the appraised value of your home. For instance, if you owe $100,000 on your $300,000, the most you can borrow would be $140,000. The $100,000 mortgage and $140,000 home equity loan equal 80% of the home’s $300,000 value.
If you’re a Texan looking to take out a HELOC, home equity loan, or cash-out refinance, there are a few other things you’ll want to keep in mind.
- You can only have one outstanding equity loan at a time. This means that you can’t have both a HELOC and a home equity loan at the same time.
- You can only take out one home equity loan every 12 months. Even if you completely pay off your loan, you cannot take out another one until a year has passed.
These laws are designed to protect consumers from making poor borrowing decisions that risk their homes. Though home equity loans can be a great financial tool, misusing them can have serious consequences.
How to Use a Home Equity Loan
How you use your home equity loan is up to you as there are no guidelines outlining how you have to spend your money. Common ways that people use their equity include:
- Home improvements and renovations, which increase your home’s value
- Consolidating expensive debt into one loan
- Paying for a child’s education
While you can use your home equity to pay for just about anything, there are some things that experts advise against. Using your home to buy into speculative investments, such as stocks or cryptocurrency, can spell disaster. Because these types of investments are volatile, you can quickly lose money, the ability to pay back the loan, and your home.
Similarly, it’s not wise to use the money to live above your means. Sure, a lavish vacation or a luxury car would be nice to have, but remember that borrowing against your home equity doesn't mean free money. You still have to repay your loan, with interest.
If you don’t have the means to repay the money, do not take out the loan.
Meet your Goals with Your Home Equity
Home equity loans and lines of credit and cash-out refinances can be used to help you meet your financial goals. By using your home’s equity as collateral, these options can put some cash in your pocket at a lower cost than other forms of financing. But as with any form of financing, it’s important to first do your research beforehand and understand the risk involved with taking on more debt.