Home equity, or the difference between what you owe on your home and it’s worth, can be used in many ways. You can invest in real estate, start or expand a business, continue your education, consolidate high-interest debt, make costly home improvements or use it in any other way you see fit. This guide explores these strategies, the potential risks of tapping into your home equity, and how to leverage it to build wealth.
What is Home Equity?
Home equity is a figure that represents the amount of your home you own outright. You can tap into it through a home equity loan, home equity line of credit (HELOC), or cash-out refinance. More on these shortly.
How is Home Equity Calculated?
To compute your home equity, you’ll need your outstanding mortgage balance and the market value of your home. Once you have these figures handy, use this formula to calculate the amount of equity you have in your home.
Here’s the formula:
Market value – Mortgage Balance = Home Equity
To illustrate, if your home is worth $365,000 and your mortgage balance is $235,000, your home equity is $130,000 ($365,000 – $235,000).
The Importance of Home Equity
For starters, if you have equity in your home, you’re not underwater on your mortgage. This is a significant upside, as being underwater means you owe more than your home is worth. In this situation, it can be challenging to refinance your home. And if you need to sell it, you’ll lose money on the deal.
Methods to Access Home Equity
You can convert a portion of your home equity into cash through a home equity loan, home equity line of credit (HELOC), or a cash-out refinance.
Home Equity Loans
A home equity loan is a second mortgage that gives you a lump sum of cash. The interest rate is fixed, so you’ll repay the loan in equal monthly installments spanning five to 30 years.
Most lenders let you borrow up to 85% of the equity you have in your home. So, if you owe $255,000 and your home is worth $405,000, you could potentially access a home equity loan of up to $89,250 ($405,000 * .85 – $255,000).
Home Equity Lines of Credit (HELOCs)
A HELOC works like a credit card, giving you access to a line of credit you can borrow from up to a specific limit as needed. Withdrawals are permitted during the draw period, which typically ranges from five to 10 years. During this window, many lenders only require interest payments.
When the draw period ends, the repayment period commences and can extend up to 20 years. You’ll be on the hook for principal and interest payments that will fluctuate since the interest rate is generally variable on HELOCs.
Like home equity loans, the limit on HELOCs is usually capped at 85% of your home equity.
Cash-Out Refinancing
A cash-out refinance involves swapping out your current mortgage for a new, larger one with different terms. The difference between the two represents the home equity you pull out – typically capped at 80%.
To illustrate, assume your home is valued at $450,000, and you owe $247,000 on your current mortgage. If the lender approves you for a cash-out refinance, you could potentially pull x from your home equity in cash $113,000 ($450,000 * .80 – $247,000). This amount would be disbursed to you, and you’d get a new mortgage for $360,000 ($247,000 + $113,000).
Once the new loan closes, the lender will pay off your existing mortgage and disburse the funds you pull out. You will then resume payments but on the new home loan.
How to Use Home Equity to Build Wealth
Using Home Equity to Invest in Real Estate
- Purchasing Rental Properties: You can buy rental properties and create a steady stream of income through tenant rent payments.
- House Flipping: There’s also the option to purchase, renovate and sell fixer-uppers for a profit.
- Investing in REITs: If you choose to invest in real estate investment trusts (REITs), you can diversify your real estate portfolio without having to manage properties directly.
Leveraging Home Equity for Business Ventures
- Starting a New Business: You can convert your home equity into cash and use the funds to bring your business idea to life.
- Expanding an Existing Business: If your business is already up and running, funding from your home equity can help you expand operations, whether it’s through new locations, increased inventory or additional staff.
Home Equity for Education and Professional Development
- Financing Higher Education: You can use the funds to cover higher education costs and avoid costly private student loans.
- Funding Vocational Training and Certificates: Investing in vocational training or professional certificate programs using home equity can also help you advance your career.
Debt Consolidation Using Home Equity
- Paying off High-Interest Credit Cards: Consolidating costly credit card debt can help you pay the balances off faster and potentially save a bundle in interest.
- Managing Other Personal Debts: You can also tap into your home equity to consolidate other personal debts and make them much more manageable.
Home Improvements and Renovations
- Enhancing Property Value: The right home improvements and repairs can boost your property value and provide a higher return on investment when you’re ready to sell.
- Energy-Efficiency Upgrades: You can also make energy-efficient upgrades using these funds to lower your utility bills and make your home more attractive to prospective buyers.
The Risks and Considerations of Using Home Equity
Despite the upsides of using home equity, there are potential risks to keep in mind before moving forward with a home equity loan product.
Possibility of Foreclosure
The most significant risk of tapping into your home equity is the risk of foreclosure. As previously mentioned, home equity loans and HELOCs act as second mortgages. So, missing payments give the lender the right to foreclose on your home and sell it to recoup what’s owed.
If you take out a cash-out refinance on default on the mortgage, you could face the same financial consequences.
Owing More Than Your Home Is Worth
Your home equity dips when you tap into it through a home equity loan, HELOC or cash-out refinance. If market conditions decline and your property loses value, you risk owing more on your home than it’s worth. This is called being underwater on your mortgage and can make refinancing or selling your home challenging.
Credit Score Impact
When you apply for a home equity loan product, your credit score will take a dip with the hard inquiry. You could also see a change if you get a HELOC and exceed 30% of the limit since it’s a revolving line of credit, and amounts owed on these types of accounts account for a sizable amount of the credit scoring equation.
If your payments are more than 30 days late, your credit score could also take a hit since payment history is the most significant component of your credit score. So, it’s vital to manage your home equity loan, HELOC, or cash-out refinance loan responsibly and make timely payments to preserve your credit health.
Legal and Tax Implications
Interest paid on home equity loan products and cash-out refinances may be deductible if used to substantially improve your home. Consult with a reputable tax professional to learn more or to determine your eligibility for this deduction.
Expert Tips and Strategies on How to Use Home Equity to Build Wealth
If used properly, your home equity can help facilitate the wealth-building process.
Long-Term vs. Short-Term Goals
Ideally, you want to use home equity to help you meet long-term goals, like consolidating debt to pay it off sooner and free up funds to invest. Or you can fund costly home renovations to increase your property’s value.
Short-term goals could include investing in business ventures or continuing your education. Either way, doing so could increase your income potential sooner rather than later.
Timing and Market Conditions
There’s no way to control market conditions, and as they change, the value of your home could follow suit. That said, it’s best to tap into your home equity when market conditions are available, as you’ll have more equity to work with.
Be sure to keep an eye on interest rates as well. More competitive rates can make home equity loans and HELOCs far more attractive when rates are lower, as you’ll incur fewer borrowing costs.
Working with Trusted Lenders
It’s also vital to choose a reliable lender before converting your home equity into cash. Look for those who are transparent and offer competitive terms. Online reviews from past and current customers can provide the insight you need to make an informed decision.
Conclusion: Making Informed Decisions on Using Home Equity to Build Wealth
Using home equity to build wealth can be a rewarding but risky strategy that requires careful planning. Be sure to get clear on your financial goals, be mindful of current market rates, conduct a cost-benefit analysis, and do your research to find the best loan product and lender to meet your needs.
