What Is Home Equity and How Does a Home Equity Loan Work?

What Is Home Equity and How Does a Home Equity Loan Work?

A recent report in National Mortgage News revealed good news for homeowners. Thanks to escalating home prices, and people deciding to stay in their homes rather than selling, mortgage borrowers are sitting on a combined total of $11 trillion in untapped equity. That breaks down to a whopping average of $270,000 per American borrower.

Simply put: home equity is the value of the interest in your home. Think about it as the property’s current market value minus the amount owed. Equity can fluctuate as the market changes (home values go up or down) and equity increases as you pay down any loans associate with your home. You can borrow money against the equity you’ve built, but many lenders require that you keep an “equity cushion” of 20 percent. In some cases, having that 20 percent cushion means that there will be no mortgage insurance premium to pay, and maintaining an equity cushion keeps you from ever getting “upside down” on your mortgage—possibly owing more than your home’s value.

It’s a homeowner’s boon when home equity is high, as it is now, because that surplus value represents power; power to get cash out for other uses, or to purchase another home for which you could have a sizeable down payment. And when used judiciously, it can position you for stronger financial success in the future.

What Can You Do with Your Home Equity?

Some homeowners use the equity in their home to finance improvements, such as constructing an addition or remodeling an outdated kitchen. Projects like these add to the value of your home, helping you to build even more equity. That’s a win-win whether you stay in your home or sell later.

Others may dedicate the funds toward necessary repairs. If your home is need of a new roof or it’s time to upgrade your electrical system, this could be the perfect time to cash out equity to make those essential fixes—keeping your home in tip-top shape.

The option to leverage tappable equity to pay for other, necessary expenses also exists, such as funding a child’s college education or paying off other debt taken out at higher interest rates. Credit card debt is a good example. Financial transactions like these can pay off over the long run by helping you reduce debt with lower interest rate options, which many home loans typically provide. It’s basically putting your home to work for YOU as a reward for the work and time you’ve put into your home.

Turning Home Equity to Cash

If you’re wondering how you sensibly cash out your home’s equity, there are a few different ways to go about it. It all depends upon how you plan to utilize the equity you’ve built and your plans for the future.

If you’re looking to improve cash flow or take the squeeze out of your monthly budget, a simple refinance might do the trick. In recent years, falling interest rates encouraged many homeowners to refinance mortgages from 30-year terms to a shorter 15-year term.

Now, inflation is rising and home purchases are in high demand, which means some homeowners are refinancing back to their 30-year term, allowing them to reduce their monthly mortgage payment. It may be enough to ease cash flow restrictions and provide some breathing room in your budget if the shorter-term loan proved to be just too aggressive.  

On the other hand, if you’re looking to fund repairs, remodel, or otherwise spruce things up around the house, you might consider a cash-out refinance. Taking this approach, you would refinance your existing mortgage for a larger amount than you currently owe, and the difference would be yours to spend as needed. This can often be a good strategy if you require additional funds to finance a child’s education or if you have unforeseen expenses.  

Let’s do a little math to illustrate! If you have $40,000 left to pay on your mortgage and your home’s worth $100,000 on the market today, your tappable equity equals $40,000, after subtracting your 20 percent cushion. That means, you can refinance your existing mortgage for $80,000, pay off the current loan, and have $40,000 left in cash.

A cash out refinance is a good option when interest rates are lower than the rate on your existing mortgage, but what if current interest rates are higher? Don’t despair. You can also consider taking out a home equity loan.

A home equity loan is essentially a second mortgage on your home. Instead of refinancing your existing mortgage, you take out a second loan, using your tappable equity as collateral. Some borrowers prefer this loan type because you can borrow, or draw from a line of credit, in smaller amounts.

When taking out a home equity loan, borrowers have a few different options:

• Take a lump sum payment. Using our example above, if you were to take out a $40,000 loan against your tappable equity, you’d receive the entire amount all at once to be used toward improvements on your home or other expenses.
• Receive the loan payout in installments. Lenders may refer to this type of home equity loan as a HELOC, since it acts as a home equity line of credit, allowing you to draw from the balance as you do from your checking account. With a HELOC, you pay interest only on the amount you draw up to an established limit.  

No matter which you choose, it’s important to note that there can be fees associated with taking out any loan. That’s why it’s advisable to find a reputable loan officer to help you understand all of your loan options and whether cashing in on your home equity is the best course of action for your situation.

A loan officer is your ally when you evaluate your short- and long-term goals and your current financial position. They will guide you through your options. While the equity in your home can give you the freedom of purchasing or borrowing power, you’ll want to harness the most knowledge possible before taking your next steps.