If you’re looking for a way to cover college tuition, pay for a home improvement project, or take care of another major expense, you might consider home equity financing. This type of financing lets you borrow against the difference between how much your home is worth and how much money you still owe on your mortgage. You gain equity in your home as you reduce your loan balance through monthly payments and as your home’s value appreciates over time.
You can get equity out of your home by taking out a home equity loan, home equity line of credit (HELOC), or cash-out refinance loan. Among the possible advantages of these types of lending are lower interest rates than other types of credit and tax deductions for interest paid on loans. But the potential drawbacks include losing your home to foreclosure if you fall behind on loan payments, losing the equity you’ve built up in your home, and paying fees and other lending expenses.
- Home equity loans, home equity lines of credit (HELOCs), and cash-out refinance loans are the three basic ways of getting equity out of your home.
- Home equity loans, HELOCs, and cash-out refinance loans generally offer lower interest rates than credit cards and personal loans.
- Lenders consider factors such as your credit history, income, and amount of home equity when deciding whether to offer you an equity-based loan.
- With any type of home equity lending product, you run the risk of losing your home if you fall behind on loan payments.
How To Pull Equity Out of Your Home
Generally, homeowners can take advantage of three options for using their home equity: home equity loans, HELOCs, and cash-out refinance loans.
Home Equity Loans
When you take out a home equity loan, a lender gives you a fixed sum of money that usually must be paid back in equal monthly amounts over a fixed period of time. In this regard, a home equity loan is similar to a traditional mortgage. Lenders typically let you borrow up to 85% of the home equity you’ve accumulated.
Sometimes known as a second mortgage, a home equity loan is backed by your home. If you fail to make loan payments as instructed by the lender, you might wind up losing your home through foreclosure. The lender might then sell your home to recover the money owed on the loan.
A home equity loan can be ideal for a homeowner who needs a lump sum to cover a big expense, such as a kitchen remodel or a child’s college tuition. It also can be useful for consolidating and paying off higher-interest debts, such as credit card balances.
Other potential advantages of home equity loans include:
- Repayment periods can last five to 30 years, depending on your lender.
- Tax deductions on the interest you pay might come into play if you use the loan proceeds to pay for substantial home improvements.
- Interest rates are generally lower than they are for credit cards.
A home equity loan normally comes with a fixed interest rate. Lenders charge interest on the entire amount of the loan, regardless of whether you actually spend all of the money. Interest charges for HELOCs and cash-out refinance loans work differently.
Other potential disadvantages of home equity loans include:
- You must make simultaneous payments on the original mortgage and the home equity loan.
- Interest rates, at least early on, may be higher than they are for HELOCs.
- Interest rates are typically higher than they are for cash-out refinance loans.
A HELOC is a revolving line of credit that enables you to borrow against your home equity. It’s similar to a credit card. A HELOC lender authorizes a certain amount of credit, typically letting you borrow as much money as you want, whenever you want—as long as you don’t exceed the credit limit. You can access the money from your HELOC by writing a check or using a credit card connected to the HELOC.
HELOCs are geared toward covering expenses such as:
- Major home improvement projects
- College tuition
- Consolidation of higher-interest credit card debt
The credit limit assigned for a HELOC depends on factors such as the amount of home equity you have, your income, and your credit history. In some cases, you might qualify for a credit limit that greatly exceeds the typical limit on a credit card.
As with a home equity loan, a HELOC is backed by your home. This means that if you don’t make timely HELOC payments, the lender could seize your home through foreclosure and then sell it.
HELOCs typically feature a draw period, which is a set amount of time when you can borrow money. Once the draw period ends, you might be able to renew the line of credit. If not, you’ll likely need to start paying off the money you’ve borrowed.
The interest rate on HELOCs compared to home equity loans can be structured differently. A HELOC’s annual percentage rate (APR) is based only on interest, not on points and other financing charges. The APR for a home equity loan includes points and other financing charges.
HELOC interest rates are generally lower than those of credit cards, and you may be able to initially make monthly payments only on the interest.
Potential advantages of HELOCs include:
- Interest rates, at least early on, are often lower than they are for home equity loans.
- Tax deductions on the interest you pay may be possible if you use the loan to pay for substantial home improvements.
- Initially, interest-only payments are made on the money you use, not on the total amount available under your credit limit.
Those benefits might be offset by some drawbacks, though. For instance, HELOCs typically have variable interest rates rather than fixed ones, which means your interest rate and payment amounts can rise or fall over time.
Other potential disadvantages of HELOCs include:
- The lender may freeze or cancel the HELOC if the value of your home goes down.
- If you sell your home, your lender may require you to pay off the HELOC at the same time that the sale closes.
- There’s no lump-sum amount of cash, unlike what you’d get with a home equity loan or cash-out refinance loan.
Cash-Out Refinance Loans
A cash-out refinance loan offers another way to tap into a home's equity.
When you take out a cash-out refinance loan, you replace your existing mortgage with a new mortgage. In other words, you switch out one first mortgage for another, as opposed to taking out a second mortgage like a home equity loan or HELOC. The new loan might even provide different terms, such as a shorter payoff period or a lower interest rate. The refinance loan carries either a fixed or variable rate and typically provides a payoff period of up to 30 years.
A cash-out refinance loan is geared toward a homeowner who has built up a sufficient amount of equity. Proceeds from this loan pay off the original mortgage and cover closing costs, and any remaining money goes to the borrower in a lump sum. The borrower can spend the lump-sum amount however they want, such as to consolidate debt, fund a home improvement project, or pay off student loans.
Keep in mind that the lump-sum amount of money taken from the equity becomes part of the principal owed on the new loan. The principal includes the amount of money you agreed to borrow and excludes the interest you'll pay to borrow that money.
One of the advantages of a cash-out refinance loan is that you may end up with a lower interest rate compared with your existing mortgage. In addition, you might qualify for a tax deduction on the mortgage interest that you pay.
Other advantages of cash-out refinance loans include:
- Once you use the funds to pay off the original mortgage, you'll get any money left as a lump sum.
- Overall monthly debt payments may decrease if you put the loan's proceeds toward debt consolidation.
- Replacing the original mortgage with a cash-out refinance loan may enable you to switch from a less stable adjustable-rate mortgage to a more stable fixed-rate mortgage.
One of the drawbacks of a cash-out refinance loan is that if your home's value declines in the future, you might owe more than what your home is worth. However, this risk exists with any mortgage loan, meaning it's not exclusive to a cash-out refinance loan.
Other disadvantages of cash-out refinance loans include:
- You're taking on more debt, which could hurt your overall financial health.
- Your home serves as collateral for the new loan, just as it did for the original mortgage. If you fail to consistently make on-time loan payments, the lender could foreclose on your home.
- Closing costs for a cash-out refinance loan may be higher than they are for HELOCs.
How Home Equity Financing Works
Home equity financing—whether it’s a home equity loan, HELOC, or cash-out refinance loan—lets you tap into the equity that you’ve built up in your home. Equity is the difference between what your home is worth and how much you still owe on the mortgage. Here are some of the key aspects of home equity financing.
Home equity loans, HELOCs, and cash-out refinance loans all use your home as collateral. If you fall behind on loan payments, you could lose your home to foreclosure and even wipe out your home equity.
A lender determines how much money you can borrow through home equity financing, along with the interest rate, based on factors such as your credit history, your income, and your home’s market value.
To qualify for a home equity loan or HELOC, you’ll typically need to have at least 15% to 20% equity in your home based on its current appraised value. In other words, you’d need a loan-to-value (LTV) ratio of 80% to 85%.
To calculate the equity, a lender will look at the LTV ratio. To come up with this ratio, you divide the current balance on your primary mortgage by the current appraised value of the home. Most lenders require an LTV below 95%, although the target usually is 80% to 85%. An LTV of 80% or below may allow you to avoid buying private mortgage insurance (PMI).
Combined Loan-to-Value Ratio
For a home equity loan or a HELOC, a lender also will calculate your combined loan-to-value ratio (CLTV). This ratio takes into account all of your mortgages, including the one you’re applying for. The total of all mortgages is divided by your home’s current appraised value to calculate the CLTV. Many lenders want to see a CLTV no higher than 80%, though some will allow up to 90%.
Another number that a lender will consider in home equity financing is your debt-to-income ratio (DTI). This ratio is the amount of all your monthly debt payments divided by your gross monthly income. In many cases, a lender will want your DTI to be no higher than 43%.
Interest rates for home equity loans, HELOCs, and cash-out refinance loans vary from lender to lender. At a single lender, rates may vary depending on the loan product and your LTV, credit score, term length, and other factors.
Payoff terms may range from five to 30 years for a home equity loan and 5 to 30 years for a cash-out refinance loan, which replaces your current mortgage. However, your options for term length depend on your lender.
A HELOC starts with the draw period, during which you’re allowed to withdraw money from the HELOC credit line. A draw period typically lasts 10 to 15 years, during which the lender requires you to make interest-only payments. After the draw period, you’ll enter the repayment period, during which you’ll make both interest and principal payments. The lengths of both periods will be detailed in your agreement with the lender.
Pros and Cons of Pulling Equity Out of Your Home
Access to a large sum of cash
Lower interest rates than other loans
Home serves as collateral
- Access to large sum of cash: Tapping into your home equity provides cash you can spend on major expenses like home improvement projects, college tuition, or unexpected bills.
- Lower interest rates than other loans: Using your home equity to borrow money may be a cheaper route than relying on credit cards and other higher-interest lending products.
- Home serves as collateral: If you fall behind on loan payments, you could lose your home to foreclosure—which means you could also lose the equity you’ve accumulated.
- More debt: When you take out a home equity loan, HELOC, or cash-out refinance loan, you’re adding to your overall debt.
Alternatives to Home Equity Financing
Home equity financing isn’t the only way to borrow money. Several alternatives are available.
A credit card can be an option if you’re not comfortable typing up your home equity. One benefit of using credit cards is they can give you quicker access to money than home equity lending products. And, of course, you don’t need to own a home to use a credit card.
But credit card interest rates are usually higher than those of home equity lending products. Plus, a credit card’s spending limit may be lower than what you’d be able to borrow with a home equity lending product.
While a personal loan might not offer as much access to cash as home equity financing does, it has potential benefits, such as lower fees and faster approval than home equity financing. And, unlike a home equity lending product, a personal loan normally doesn’t require collateral. However, a home equity lending product might provide a lower interest rate than a personal loan and can offer tax breaks that aren’t available with a personal loan.
Home Improvement Loans
If you’re tackling a home improvement project, you might be able to take out a home improvement loan, which is essentially a personal loan designed for a specific use. The amount you can borrow is based on the estimated after-improvement value of your home. A home improvement loan doesn’t require you to use your home or any other property as collateral. Plus, you might be able to borrow money even if you have little to no home equity. However, home improvement loans generally charge higher interest rates than home equity lending products.
Frequently Asked Questions (FAQs)
How do I calculate how much equity I have in my home?
To calculate how much equity you have in your home, subtract the amount you owe on all of the loans secured by your home from the current appraised value of the home. The difference is your amount of home equity. If your home is valued at less than what you owe, then you have no home equity (which is also referred to as being “underwater.”)
How long does it take to get a home equity loan, HELOC, or cash-out refinance loan?
The timing depends on your lender and the type of home equity financing you’re pursuing. For example, Navy Federal Credit Union takes 30 to 45 days to process a home equity loan or HELOC. Meanwhile, it takes about 45 to 60 days to close on a cash-out refinance loan from PenFed Credit Union. However, some home equity lending products might be completed more quickly.
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