There are times when we all see an investment opportunity or just need a bit extra cash for personal use or to renovate our home. But, as usually happens, we have to turn down the opportunity as we are out of cash. However, if you own a home you can tap into its equity to access cash to pay for your renovations, improve your financial position, or invest. While you have to realize the risks associated with pulling the equity out, there are ways to keep the risks in check.
In another article, we discussed 23 ways to invest or otherwise use your home equity: How to use home equity. Investing home equity. 23 ways to invest or otherwise use your home equity.
In this post, we will discuss 4 ways to withdraw your home equity to give you that cash. Before we jump into that, let's have a quick review of what home equity is.
What is home equity?
Home equity is the portion of your home that you’ve paid off plus any increase in its market value over time. In other words, it is the difference between what your property is worth and how much you still owe on your mortgage. Let's say you bought a home for $300,000 ten years ago and took a mortgage for $270,000 at that time. By now, you have paid off $90,000 of your mortgage leaving a mortgage balance of $180,000. Currently, the home you bought 10 years ago can be sold for $450,000. This means your home equity is:
$450,000 - $180,000 = $270,000
Home equity that you build over time is directly connected to your net worth. As your home’s value increases and you pay down the principal on the mortgage, your net worth grows.
Below are the 4 common ways to tap into your home's equity are:
Cash-out refinance
Home equity loan (also called the second mortgage)
Home equity line of credit (HELOC)
Reverse mortgage
What is Cash-Out Refinance?
The idea behind cash-out refinance is quite simple. Each time your mortgage term with your current lender comes to an end it is time to refinance with your current or new lender. At that moment, you are free to change any of the below mortgage terms:
Amortization period. E.g., you originally had a mortgage with a 25-year amortization period, and, let's say, you have been paying your mortgage for the past 10 years. This means that you have 15 years left in your amortization. However, you can either increase or decrease your future amortization period. If you are now making more money, you may decide to pay the remaining mortgage in just 10 years. Alternatively, if you want to reduce your monthly payments you can extend your amortization to 20 or 25 years.
Face value of your mortgage. For example, you borrowed $200,000 in mortgage 10 years ago. Since then, you paid off $50,000 and the remaining mortgage balance stands at $150,000. When you refinance for the next term, you can increase your mortgage back to $200,000 or more. The current market price of your property is the limit of how much you can increase your mortgage. Most lenders will extend your mortgage to only 80% of the current property price. This rule would be also true for HELOC and Home Equity Loan.
A cash-out refinance is just increasing the face value of your mortgage, meaning you will have a higher mortgage to repay. At the same time, you receive a lump-sum cash amount.
The above 2 factors (amortization period and face value of the mortgage) are there at your disposal and can be used together. For example, if you need cash, but cannot afford a higher monthly payment, you may also increase the amortization period which will help bring the monthly payment to what you can pay.
The biggest drawback of this method of taking the home equity is that you will now have a bigger mortgage to pay off and, unless you can increase your monthly payment, will face a longer amortization period which may take you well into your retirement.
The benefit of this method is that, unlike other methods (HELOC and home equity loan), you will get the same interest rate as you would otherwise get on your mortgage. This means you are borrowing money for your personal needs at a rate much lower than you would have to pay for a common unsecured line of credit.
Cash-Out Refinance Benefits
❑ Substantial lump sum payment received immediately
❑ The lowest interest rates are similar to what you would get for your mortgage.
❑ Flexibility to chose variable or fixed rate.
❑ Can increase amortization period to lower monthly payments.
Cash-Out Refinance Risks
❑ Lack of flexibility in repayment plan - you repay monthly according to a preset plan.
What is a Home Equity Loan?
Also known as a second mortgage, this type of home loan is very much like a regular mortgage with an amortization period, and a pre-set monthly payment covering interest and a portion of the mortgage principal. Similar to a normal mortgage, you can pick a variable or fixed rate; however, most of the banks will push you into a fixed rate due to higher risk for the second mortgage. The second mortgage typically comes with a higher interest rate as it carries an increased risk to the lender because:
1. you would have to pay 2 mortgage payments: one for the primary and one for the secondary mortgage,
2. If you default on your payments, the first mortgage would take priority for repayment through the sale of your property. There may be no money left to repay the second mortgage.
Home Equity Loan Benefits
❑ Substantial lump sum payment received immediately.
❑ Home equity loans have fixed interest rates, meaning your payments will be the same every month.
❑ Fixed rate that limits volatility of payments.
Home Equity Loan Risks
❑ Having to manage 2 mortgage payments.
❑ The relatively higher interest rate for the second mortgage.
❑ Higher closing rates since you need to apply for a second mortgage.
❑ Lack of flexibility in repayment plan - you repay monthly according to a preset plan.
What is Home Equity Line of Credit (HELOC)?
A HELOC is a Line of Credit secured by real property. A line of credit (LOC) is an amount of credit made available to a borrower but not advanced on closing. For example, if a borrower has a $100,000 LOC, he or she would be able to use these funds whenever he or she wished.
Thus, payments are only made on the outstanding balance of the HELOC. A typical HELOC has monthly payments of interest only based on a variable rate. The borrower can make payments as small as the interest-only or as large as he or she wishes. This makes HELOC a type of revolving credit, similar to a credit card when a person can draw money against HELOC, repay, and then use it again.
Home Equity Line of Credit Benefits
❑ Flexibility. This plan allows the borrower to borrow funds as necessary and make repayments that fit his or her budget (as soon as you cover the interest).
Home Equity Line of Credit Risks
❑ Volatility. A HELOC contains the same rate volatility as a variable rate mortgage.
Below is the summary of the differences between Cash-Out Refinance, Home Equity Loan, and HELOC:
Cash-Out Refinance | Home Equity Loan | HELOC |
|---|---|---|
Everything combined under 1 mortgage | Done with a second mortgage: 2 mortgages on the same property to manage | Done as a separate Line of Credit account: 1 mortgage and 1 Line of Credit to manage |
Your choice between fixed or variable rates | Predominantly fixed rate | Variable rate |
Provided in a lump sum | Provided in a lump sum | Revolving credit, works like a line of credit: Flexibility to take only the credit you need, when you need |
Repaying starts immediately: interest and principal | Repaying starts immediately: interest and principal | Flexible payments as soon as you cover the accumulated interest. |
Lowest interest rate | Highest interest rate | Medium interest rate |
What is a Reverse Mortgage?
A reverse mortgage in some sense is resembling a HELOC. As with HELOC, it is a loan secured against the value of your home. As with HELOC, you tap into the home equity that you have in your property. The bank gives you money today that you have to repay later. There is only one key difference: you actually don't have to repay this money or the interest that it accrued until you decide to sell this property or all homeowners for this property die. A reverse mortgage is also only reserved for seniors. This makes a Reverse Mortgage a somewhat unique way to take equity out of your property. I will write a separate article about a Reverse Mortgage in future posts.
In summary, knowing the pros and cons of each of the options to withdraw the home equity from your property is important to manage risks and calculate the impact of the additional loan on your monthly payments and budget. Consider consulting with a mortgage broker before engaging in the home equity transactions. However, proper planning and calculation of the interest, terms, monthly payments, and the income that you may get from the invested home equity may well outweigh the interest you have to pay on the loan.