Homeownership offers numerous advantages, one of the most significant being the equity you build in your property. Your home equity can serve as a powerful financial tool, enabling you to finance major purchases, undertake costly renovations, eliminate high-interest debt, or even contribute to retirement planning.
When you decide to access your home equity, you have a variety of options. Let’s explore these possibilities and differentiate between the various types of home equity financing available today.
Home Equity: An Overview
Simply put, home equity is the portion of your home that you own free and clear, unburdened by debt tied to the property. Your home equity naturally grows over time as you consistently make your monthly mortgage payments and as your home’s market value appreciates.
To calculate your current home equity, you simply subtract your outstanding mortgage balance and any other obligations secured by your home from its total market value. For example, if your home is appraised at $500,000 and you owe $300,000 on your mortgage, you have $200,000 in home equity.
Types of Equity-Backed Financial Solutions
The market currently offers more financial solutions tied to home equity than ever before. While each product has unique characteristics, a common thread among them is that they are all secured by your home. This means the lender places a lien on your property, and in the event you fail to meet the terms of your contract, your home could be at risk. Although this might sound intimidating, this security generally translates to more favorable interest rates compared to unsecured financial products like personal loans or credit cards.
Let’s delve into the most popular types of equity loans and similar products:
1. Home Equity Loan (HEL)
The most straightforward product on this list, a home equity loan is often referred to as a second mortgage.
How it works:
- You receive a lump sum of cash at closing.
- It comes with a predictable, fixed-rate monthly payment.
- The repayment term typically ranges from 5 to 30 years.
Requirements:
- Credit Score: A common threshold for lenders is 680, though some may go as low as 630.
- Debt-to-Income (DTI) Ratio/Income: You’ll generally need a DTI of under 43% and a steady, documented income to qualify.
- Home Equity: Most lenders require you to have at least 15% equity in your home, with 20% being more common.
- Other: Many lenders prefer to work with primary residences, making it potentially more challenging to secure a home equity loan against investment properties.
Considerations:
- Ideal if you prefer the predictability of fixed-rate loans and consistent monthly payments.
- You might pay a slight premium (a slightly higher interest rate) for the security and predictability of a fixed rate compared to variable-rate options.
2. Home Equity Line of Credit (HELOC)
In contrast to the fixed-rate home equity loan, a HELOC generally comes with a variable interest rate, and its operational behavior is quite different.
How it works:
- HELOCs are revolving credit lines tied to your home, functioning much like a credit card.
- The life of a HELOC is divided into two phases:
- Draw Period (most often 10 years): During this time, you can withdraw funds from your line of credit, up to your maximum approved amount. You are typically required to make interest-only payments on the amount you’ve borrowed, though you can choose to pay down principal. As you repay principal, those funds become available to draw again.
- Repayment Period (most often 20 years): Once the draw period ends, you can no longer take out additional funds, and your payments switch to cover both principal and interest.
- The interest rate is variable, often tied to the Wall Street Journal Prime Rate, meaning your payments can fluctuate with market conditions.
Requirements:
- HELOCs have almost the same requirements as home equity loans:
- Credit Score: Common threshold is 680, some lenders may accept as low as 630.
- DTI/Income: Under 43% DTI and steady, documented income.
- Home Equity: At least 15% equity, with 20% being more common.
- Other: Similar limitations on investment properties as home equity loans.
Considerations:
- HELOCs generally have lower closing costs, but be aware of other fees such as annual fees or draw fees (for each withdrawal). Some institutions may also have minimum draw amounts. Always understand all associated costs before proceeding.
- Crucially, plan for the shift from interest-only payments to principal and interest payments during the repayment period, as this can significantly impact your budget.
3. Cash-Out Refinance
If you have an existing mortgage, a cash-out refinance replaces that mortgage with a larger amount, allowing you to “pocket the proceeds.”
How it works:
- You pay off your current mortgage with a new, larger mortgage.
- The difference between your old mortgage payoff and the new, larger loan amount is given to you in cash.
- Similar to a regular mortgage, a cash-out refinance can have fixed or variable interest rates and terms ranging from 5 to 30 years. The 30-year fixed-rate mortgage remains the most popular.
Requirements:
- Credit Score: Minimum of 580, but many lenders prefer 620 or higher.
- DTI/Income: You’ll need a DTI of under 50% (some lenders stick to 43%) and sufficient income to cover the new, higher mortgage payment.
- Home Equity: You’ll generally need at least 15% equity, though some lenders may allow you to borrow up to 95% of your home’s value (especially with VA loans for eligible borrowers).
Considerations:
- Impact on Interest Rate: You must carefully consider the new interest rate compared to your existing mortgage rate. If your current mortgage is at 3% and you refinance at 7%, the long-term cost can be substantial.
- Higher Closing Costs: Closing costs for a cash-out refinance tend to be higher than for a home equity loan because they are calculated as a percentage of a larger loan amount.
4. Home Equity Investment (HEI) / Home Equity Agreement (HEA)
An HEI is distinctly different from a traditional loan; it’s a financial product that serves as a worthy alternative for homeowners, particularly those with unconventional financial situations or who wish to avoid large monthly payments.
How it works:
- You receive a lump sum of money from the HEI provider.
- In exchange, you grant the provider a share of your home’s future appreciation.
- There are no monthly payments.
- You repay the HEI with a balloon payment at any time before the end of the term (typically 10 or 30 years, depending on the provider), most often when you sell or refinance your home.
Requirements:
- Credit Score: Generally more flexible, often 500+.
- DTI/Income: No DTI or income requirements, making it accessible to those with irregular income or high debt.
- Home Equity: You’ll need a large amount of equity, but the exact percentage varies by HEI company.
- Other: Because it’s a newer product, availability is geographic. Investment properties may be eligible, but manufactured homes and farms on acreage are generally not.
Considerations:
- Uncertain Repayment Amount: Since repayment is tied to your home’s future value, the exact amount you owe will not be known until it’s time to repay. It’s crucial to have an exit plan for how you will repay the HEI.
- You are still responsible for property taxes, insurance, and home maintenance.
5. Reverse Mortgage
This solution is designed specifically for seniors (age 62 or older) who want to stay in their homes but wish to access their home equity to supplement retirement income.
How it works:
- You receive cash in various forms: a lump sum, monthly payments, a line of credit, or a combination.
- The term lasts as long as at least one owner on the title lives in the home for most of the year.
- The loan balance accrues interest over time, but you do not make monthly repayments.
- The debt only becomes due when the homeowner stops living in the property (e.g., moves out permanently, sells the home, or passes away).
Requirements:
- Credit Score: Some reverse mortgage lenders have no credit score requirements.
- DTI/Income: No DTI or income requirements for qualification (though ability to pay property charges is assessed).
- Home Equity: You’ll typically need to own at least 50% equity in your home.
- Age: Only homeowners aged 62 or older are eligible. The older you are, the more of your equity you are generally eligible to borrow.
Considerations:
- If you still have a first mortgage, you’ll need to pay it off using the proceeds of the reverse mortgage.
- Since the loan becomes due when the homeowner on the title passes away, it can complicate passing the property on to heirs, as they would need to repay the loan to retain ownership.
Taking Equity Out of Your Home: Commonalities
Regardless of the specific type of equity-backed solution you choose, a few common characteristics apply:
- The loan (or financial instrument) is backed by your home, meaning there’s a risk of losing your home if you fail to meet payment terms (or repayment terms for HEIs/reverse mortgages).
- Your home will likely need to be appraised (or otherwise valued) as part of the application process to determine its current market value and your available equity.
- You’ll undergo an underwriting process, similar to when you initially purchased your home, where the lender assesses your financial situation.
- These processes generally take longer than obtaining an unsecured loan, such as a personal loan, due to the comprehensive underwriting and valuation steps involved.
FAQs
What is the difference between a HELOC and a home equity loan?
A HELOC is a revolving line of credit that allows you to borrow as needed, typically with a variable interest rate, while a home equity loan provides a lump sum upfront with a fixed interest rate and fixed monthly payments, functioning more like a second mortgage.
What is the cheapest way to get equity out of your house?
The “cheapest” way depends on your individual financial situation, including your credit score, DTI, and specific needs. It’s crucial to compare interest rates, fees, and long-term costs across all available options.
What type of loan is an equity loan?
An equity loan is a secured loan, meaning it is backed by an asset—in this case, your home—which serves as collateral.
Final Thoughts
The array of home equity solutions available to homeowners today is broader than ever. If you’re looking to unlock your home equity, especially if you desire no monthly payments, or have unconventional income or credit situations, exploring options like a Home Equity Investment from providers like Point (as mentioned in the original text) might be beneficial.
Ultimately, the best choice for accessing your home equity depends on your individual financial goals, risk tolerance, and repayment capacity. Always compare benefits, interest rates, and terms across various financing options to make an informed decision.