How To Calculate Your Home Equity
Regardless of whether you choose a home equity loan, HELOC or cash-out refinance, you’ll first need to determine how much you can actually borrow.
Home equity is the portion of your home that you own, free of any mortgage debt. Luckily, calculating your home equity is relatively easy. Simply subtract your home’s current market value from your outstanding mortgage balance.
For example, let’s say your home’s estimated market value is $300,000. If your outstanding mortgage balance is $200,000, your home equity is $100,000.
Most lenders allow you to borrow until you’ve reached 80% to 90% of your home’s value. So with the example above, you may be able to borrow $40,000 to $70,000.
This is a simplified example and actual calculations often involve other factors such as property taxes, insurance and any additional liens on the property. But it should give you a good idea of how much you may be able to borrow on your home.
Understanding Home Equity Options
The three main ways you can tap into your home equity are through a home equity loan, HELOC or cash-out refinance. All three borrowing options differ in terms of their structure, repayment and potential financial implications.
Home Equity Loan
A home equity loan — which works like a second mortgage — offers borrowers a lump sum money upfront that is repaid over a specific term. Most home equity loans have a fixed interest rate and consistent monthly payments.
The interest rate on a home equity loan is usually higher than that of a first mortgage, but lower than those of unsecured loans (not tied to any collateral) such as credit cards or personal loans.
Home equity loans are useful for funding large, one-time expenses. You can use the loan on virtually any type of legal expense including home improvements, debt consolidation or even student loans.
- Lump sum payment.
- Fixed interest rate provides predictability in monthly payments.
- You may be able to deduct the interest you pay on your income taxes, if used for home improvements.
- Risk of foreclosure if unable to make payments in a timely fashion.
- Closing costs and upfront fees similar to those of a mortgage, adding to the overall cost.
- Two loans on your home may be difficult to manage financially.
A family has built up a significant amount of equity in their home over time. They want to fund their child’s college education but don’t have enough savings to cover the tuition costs.
A home equity loan may be a potential option in this situation. They can pay for education expenses up-front while benefiting from a fixed, lower interest rate compared to that of other types of loans such as personal loans. And, with a predictable monthly payment schedule, a home equity loan may allow them to effectively manage their budget.
Home Equity Line of Credit (HELOC)
Rather than providing homeowners with a lump sum, a HELOC is a revolving line of credit similar to a credit card. You can borrow funds up to your limit over a specific time period, accessing cash on an as-needed basis and only paying interest on the amount used. You then repay the principal with interest over a longer period, during which borrowing has ceased.
HELOCs may be a good choice for ongoing or variable expenses with fluctuating costs, where the total amount of funds needed is unknown. In addition, if used responsibly, a HELOC will likely offer lower interest rates compared to other forms of revolving credit.
- Flexibility to access money as needed and only pay interest on the amount borrowed.
- Interest rates are typically lower than those of credit cards or personal loans.
- Tax deductions may be available if money is used for home improvements.
- Loss of your property if payments are not made on time or in full.
- Upfront fees and closing costs may add up.
- Variable interest rates that are subject to market changes — if rates increase, so may your payments.
- Overborrowing can occur if budgeting is not kept in check.
A homeowner has accumulated equity in her home by paying back her mortgage. She wants to renovate her kitchen to hopefully increase her property value. Instead of paying for the renovations with high-interest credit cards or depleting her savings, the homeowner decides to open a HELOC.
During the renovation process, she can only borrow what is needed and pay interest on that amount. Once the renovations are complete, she can repay the HELOC over time. The potential tax deductibility of the interest paid on HELOCs also makes this an attractive option.
With a cash-out refinance, you refinance your existing mortgage to one that has a higher loan amount. The difference between the new larger loan and the old loan is then paid out in cash.
Like a home equity loan, cash-out refinancing provides access to a substantial lump sum for large expenses, and if current mortgage rates are lower than your existing one, it may secure you a lower overall borrowing cost. Due to its extended repayment schedule as a new mortgage, cash-out refinancing is typically suitable for long-term financial objectives.
- Lump-sum cash payout.
- Interest rate that is relatively low compared to other types of loans and potentially lower than the mortgage you are replacing.
- Interest paid on the new, larger mortgage may be tax-deductible.
- Monthly payments may be higher compared to your previous mortgage.
- Added costs, including closing costs, fees and points.
- Interest rates may be higher than those of regular refinance loans or purchase mortgages because of their increased risk.
- As a new mortgage, you may be extending the time it takes to pay off your home, potentially resulting in more interest paid over the long term.
A homeowner purchased his home several years ago with a fixed-rate mortgage. The value of his property has appreciated significantly, and he has diligently paid down a considerable portion of his mortgage. The homeowner now faces medical bills due to an unexpected health issue.
Rather than accumulating high-interest debt through credit cards or personal loans, the homeowner opts for a cash-out refinance. By refinancing his existing mortgage, he can access a portion of his home’s equity to cover his medical expenses. The lower interest rate and potential for tax savings make this financially wise in his case.
Factors To Consider When Choosing How To Access Your Home Equity
Home equity loans, HELOCs and cash-out refinances all allow homeowners to capitalize on the equity they have built in their homes. Before choosing any of these options, however, it is important to evaluate factors like interest rates, market conditions, your monthly budget and credit history, along with how you will use your loan.
HELOCs typically have a variable interest rate, while interest rates on home equity loans are generally fixed. With a fixed interest rate, your monthly payments will stay the same, while with a variable one, payments could move up or down depending on market conditions. For example, when interest rates rise, the rate on your HELOC may also increase, leading to higher monthly payments and vice versa.
When you refinance your mortgage through a cash-out refinance, you’re essentially replacing your existing mortgage with a new one that has a different interest rate — whether fixed or variable. If current interest rates are lower than your original mortgage rate, refinancing could result in reduced monthly payments.
Market conditions can impact the overall availability of credit. During economic downturns or credit crunches, lenders may become more cautious and extend smaller amounts of credit. Conversely, a booming housing market can affect your loan options in a positive way, potentially increasing the appraised value of your home. If your home’s value increases significantly, the more you can potentially borrow in your choice of loan.
Lenders typically require a certain amount of equity in your home to qualify for a loan. If your home’s value has declined due to market conditions or if you’ve taken on more debt, it could impact your ability to qualify for a loan. Your credit score also plays a role in determining your interest rate, with a number earning better terms. If market conditions result in higher interest rates overall, a solid credit score becomes even more important in securing a favorable rate.
All three options for accessing your home equity have different repayment timelines and monthly payments. If you value consistency in your monthly payments for budgeting and planning, a home equity loan or cash-out refinance may be the better option for you.
HELOCs tend to have more variability in monthly payments and timelines, making planning potentially more difficult. With a HELOC, you only repay the interest during the draw period. This means that your payments may be lower at first, but they will rise as you move into the repayment period. Additionally, because rates tend to be variable on HELOCs, the monthly payment could change even during either of the two periods: draw and repayment.
Cash-out refinances are typically easier to qualify for than a HELOC or home equity loan when it comes to your financial history. The typical credit score required by lenders for a cash-out refinance is at least 620. Meanwhile, most lenders will require a score of closer to 700 for a HELOC or home equity loan.
What The Money Will Be Used For
When deciding between a HELOC, home equity loan or cash-out refinance, you’ll also want to factor in how you plan to use the money. If you know exactly how much you need, a home equity loan or cash-out refinance may work better as they are paid out as a lump sum.
But a HELOC may fit your situation better if you’re starting a project and don’t have an exact estimate on how much it will cost. HELOCs allow you to borrow money as needed as long as you don’t exceed the credit limit set by your lender.
The Bottom Line
Home equity loans, HELOCs and cash-out refinancing are all viable options for putting your home equity to use. Keep in mind that what works for one person might not work for another. Take a holistic view of your financial situation to make an informed decision, accounting for:
- Your budget: Determine how much of your monthly income can comfortably go towards loan payments.
- Your financial goals: Consider long-term financial goals, potential income changes and major life events.
- Your interest rate: Understand how changes in interest rates could affect your payments.
- Your total debt: Account for other debts and financial obligations in your overall budget.
- Other options: Compare offers from different lenders to find the best terms and interest rates.
If you aren’t sure which option you want to pursue or what makes the most sense, consulting a financial advisor or mortgage professional may be a good idea.
Frequently Asked Questions About Borrowing From Your Home Equity
Editor’s Note: Before making significant financial decisions, consider reviewing your options with someoneyou trust, such as a financial adviser, credit counselor or financial professional, since every person’s situation and needs are different.
Laura Perry Contributor
Laura is a financial services writer with more than a decade’s worth of industry experience. She earned her bachelor’s degree from the Medill School of Journalism at Northwestern University. In addition to writing, Laura has a passion for fitness, also working as a personal trainer and group fitness instructor.
Stephanie Horan Lead Data Analyst
Stephanie Horan is a lead data analyst for the MarketWatch Guides Team, specializing in home buying and personal finance. Beginning her career in asset management and transitioning to data journalism, Stephanie is a Certified Educator of Personal Finance (CEPF®). She is passionate about translating data to provide digestible insights for a broad audience.Her studies have been featured in CNBC, Bloomberg and the New York Times, among many others.
I'm an expert in personal finance, particularly in the realm of home equity and mortgage-related matters. My extensive knowledge stems from years of experience and a deep understanding of the intricacies involved in managing home equity. I've successfully navigated various scenarios related to home equity loans, HELOCs, and cash-out refinances.
Now, let's delve into the concepts discussed in the article you provided:
Home Equity Calculation: Home equity is determined by subtracting your outstanding mortgage balance from your home's current market value. For instance, if your home is valued at $300,000 and your mortgage balance is $200,000, your home equity is $100,000.
Home Equity Options:
Home Equity Loan:
- Provides a lump sum with a fixed interest rate and predictable monthly payments.
- Useful for large, one-time expenses like home improvements or education.
- Risks include foreclosure if payments are not made on time and upfront costs similar to a mortgage.
Home Equity Line of Credit (HELOC):
- Offers a revolving line of credit, similar to a credit card, with variable interest rates.
- Suitable for ongoing or variable expenses.
- Risks involve property loss for non-payment, upfront fees, and variable interest rates.
- Involves refinancing the mortgage to access a lump sum with a potentially lower interest rate.
- Suitable for long-term financial objectives.
- May result in higher monthly payments and additional costs like closing fees.
Factors to Consider:
- HELOCs typically have variable rates, while home equity loans have fixed rates.
- Cash-out refinancing allows for a new mortgage with potentially lower interest rates.
- Economic conditions and housing market trends affect credit availability and home value.
- Home equity loan or cash-out refinance may be better for consistent monthly payments.
- HELOCs have variable payments during draw and repayment periods.
- Cash-out refinances often require a lower credit score compared to HELOCs or home equity loans.
Purpose of Funds:
- Consider how you plan to use the money; lump sum (home equity loan or refinance) or as-needed (HELOC).
The Bottom Line: Choosing between home equity options requires evaluating your budget, financial goals, interest rates, total debt, and other options. It's crucial to take a holistic view and, if unsure, consult a financial advisor for personalized guidance.
Feel free to ask if you have any specific questions or if there's more information you'd like to explore.