Home Equity Decisions

Maybe you want to renovate your home to avoid having to buy a new house in today's cutthroat market. Perhaps you wish to pay off higher interest credit card or student loan debt. Whatever the reason, if you are interested in tapping into your home's equity, you need to know a few things first.

How much home equity do you have?

To determine home equity, a homeowner first needs to know the home's current value. All lenders will require a home appraisal with costs normally paid by the homeowner. Generally, lenders will only allow homeowners to borrow up to 80% of the home's value.

For example, your home appraised for $350,000 and your mortgage balance is $190,000. Your home equity is $160,000 ($350k - $190k = $160k). Knowing you can only borrow up to 80% of the appraised value, or $280,000 (80% of $350k = $280k), the total amount you can access is $90,000.

Which lending option works best for you?

Cash-Out Refinance. The homeowner essentially pays off the existing mortgage and replaces it with a new (and bigger) mortgage. For example, if you want to access the maximum amount of equity, you would take out a new mortgage on your $350,000 home for $280,000; pay off your current mortgage balance of $190,000, and receive $90,000 in cash.

Home Equity Line of Credit. A HELOC is a separate loan on top of an existing mortgage. The interest rate will be variable and higher than the interest rate on your first mortgage. For example, you retain your $190,000 mortgage on your $350,000 home. You now have a line of credit available to draw up to $90,000 with the flexibility to use as much or as little as you need.

Home Equity Loan. Like the HELOC, a home equity loan is a separate loan in addition to the existing mortgage. In our example, you would retain your $190,000 mortgage and receive a $90,000 lump sum payment upfront. You will have a separate home equity loan of $90,000 at a fixed rate and will have a second monthly payment.

What are the risks of tapping home equity?

• Regardless of how you access your home's equity, your home is the collateral. Don't do it if it will be difficult to make the larger mortgage payment or the additional loan payment.
  
  
• If using equity to consolidate debt, there could be a temptation to run up credit card debt again.
  
  
• Borrow only the amount necessary to meet a specific need. If you borrow the maximum of your home's equity without a plan, you may misspend the extra money.
  
  
• Suppose a new mortgage loan is secured via the cash-out refinancing option, and the term of years for the loan to be repaid is extended. In that case, you prolong the amount of time and increase the amount of interest necessary to pay off the loan. This may postpone or eliminate achieving your other goals.