How to use home equity

What can you use a home equity loan for?

Whether you want to fund your child’s education, consolidate your debt or pay for an emergency, you have a lot of freedom when it comes to using your home equity.

Many homeowners use their home equity to fund home renovations, which can increase the property value (and therefore your home equity). In most cases, though, you’re free to use your home equity for anything you want.

This doesn’t mean you should tap into your equity just because you can, though. If you take out a home equity loan, for instance, you’ll still have to pay back that loan (plus interest), meaning it’s not “free money.” If you don’t pay off the loan before you sell your house, your lender will take the remaining balance from the sale price.

How to get equity out of your home

There are a few ways to get equity out of your home, including getting a cash-out refinance, a home equity loan, a HELOC or a reverse mortgage. You may qualify for some or all of these options, depending on your situation.

Home equity loan

A home equity loan is a type of second mortgage, meaning it uses your home as collateral but doesn’t replace your primary mortgage. You get a lump sum of cash upfront and are required to repay it back in fixed monthly payments. If you fail to pay back the loan, you risk foreclosure.

Home equity line of credit (HELOC)

A home equity line of credit, or HELOC, lets you borrow up to a specific amount of cash as needed. It’s a line of credit, like a credit card, with a set limit and variable interest rate. It is another type of second mortgage.

The benefit of a HELOC over a home equity loan is that you’re able to take out only the funds you need at the moment, which can reduce the risk of overborrowing. If you have an ongoing project and aren’t sure how much it will cost in the long run or you’ll need consistent access to cash, this could be the right option for you.

Cash-out refinance

Cash-out refinancing replaces your old mortgage with a new loan for a higher amount than what you currently owe and gives you the difference in cash. As with other loan types, you’re responsible for paying back the new loan under the newly refinanced rate and terms.

Reverse mortgage

A reverse mortgage is a home equity product specifically for older homeowners — usually those 62 and older. Reverse mortgage lenders allow seniors to borrow against the value of their home and receive the funds in a lump sum, monthly installments or as a line of credit.

When you get a reverse mortgage, you don’t make payments back to the lender monthly; instead, repayment happens when the borrower dies, sells the home or moves out permanently.

When to use your home equity

So, when does it make sense to access the equity you’ve built in your home? It depends in large part on how much you have and what kinds of costs you’re facing, but you might consider tapping into your equity if you need cash for any of the purposes below.

To fund home renovations

Making renovations is one of the most common uses of home equity. Homeowners often go this route for home improvement projects for a few reasons:

• Renovating increases property value.
• Interest on a home equity loan may be tax deductible.
• Rates may be lower than on other types of loans.

To pay off debt

Many homeowners tap into their equity to consolidate debt or to pay off big expenses — like wedding, business or college debt. In some cases, this makes financial sense. In others, it just creates more expenses down the road.

Josh Richner of the National Legal Center, a consumer rights law firm focused on helping people get out of debt, offers three reasons you might consider a home equity loan to get out from under past debts:

1. You’re confident you can repay the new debt. Never swap one debt out for another without first considering the implications. If your new debt on your home equity loan is more affordable than your old one, it may be a good move.
2. The interest rates make sense. Mortgage rates are often much lower than credit card rates, but they may not be lower than student loan or traditional loan rates.
3. You can afford the payments. Taking out a loan isn’t always a bad idea, especially for something like college or a wedding. Just make sure you can afford the payments for the entirety of the loan term.

To cover emergency expenses

Tapping into your home equity can help out in an expensive emergency, especially when considering how costly other quick alternatives, like payday loans, can be. If you don’t have a realistic plan to repay the debt, though, this option could be risky.

When not to use home equity

Just because you can access your home equity doesn’t mean you should. According to Richner of the National Legal Center, “It isn't helpful to solve one problem if you're swapping it with another.”

Some people think of their home equity almost like a piggy bank. But it’s important to remember that by tapping into your equity, you’re putting your home on the line, Richner said.

Here are a few questions to ask yourself before using home equity:

• Can I afford to lose my home? There are other ways to fund certain needs, like a vacation or college tuition, without the risk of losing or going underwater on your home.
• What are the housing trends? If real estate values decrease in your area, you could end up owing more than your home is worth when it comes time to sell.
• Will my loan payments really save me money? Sometimes it’s cheaper to pay each debt separately rather than consolidate them and use your home equity to pay them off. Home equity loans may have cheaper rates, but the terms may be longer and end up costing you more in the long run.

How to calculate home equity

You can determine your home equity by subtracting the principal amount owed on your mortgage from the current market value of your home. To get the current market value, most lenders will require an official appraisal during the approval process.

If you’re curious about what your equity is but aren’t ready to work with a professional, you can also search your address on a real estate website for an estimated value.

An example: Lisa’s home is worth $450,000, according to a recent appraisal. Her outstanding loan balance is $100,000, so she has $350,000 in equity.

Lenders use what’s called the loan-to-value ratio (LTV) to determine your eligibility for a loan. Most require an LTV of 85% or lower. To calculate your LTV, divide the loan balance by the appraised value and multiple by 100.

How much equity should I have in my home before selling?

It depends on why you’re selling your home. There’s no real set-in-stone guideline, but, in general, the more equity you have built up, the better. You can use the equity toward the down payment for your next home, reducing your principal and increasing equity in your new property.

What if I’m underwater on my mortgage?

If you’re underwater on your mortgage and don’t have any equity or have negative equity in your home, the best solution is to continue building equity before you try to sell.

How to build home equity

If you want to start building equity, there are a few things you can try. Some are quicker solutions, and all require some money and diligence.

• Put down 20%: If you can put down at least 20% on a conventional loan, you won’t have to pay private mortgage insurance (PMI), which can help you build equity faster. If you get a large windfall of cash, like from an inheritance, it might be worth putting it toward your principal just to remove PMI.
• Pay extra every month: You can also pay extra every month to lower your principal faster — even an added $50 per month can make a difference. Paying your loan off faster will also help you save significantly on interest charges.
• Refinance to a shorter term: While you’ll pay more per month, a refinanced loan with shorter terms lets you pay off your mortgage faster. You may also be able to get better rates with a refinance.
• Switch to biweekly mortgage payments: Some lenders offer programs where you can pay twice per month toward your mortgage. These programs add up to one extra mortgage payment per year.
• Make smart home improvements: If you can afford home improvements without taking out a HELOC, making strategic updates (like new paint) can increase your home’s value and your equity.
• Wait it out: Home values tend to increase over time. If you can afford to wait until the market gets hot to sell, you will have increased equity in your home.

Bottom line

According to Alan Harder, a mortgage broker in Vancouver, British Columbia, it's important to compare offers from multiple lenders to ensure you get the best deal before you tap into your home equity. “If you're strategic about how you use a home equity loan, it can be a valuable tool in building your financial future,” he said.

If you’re unsure which home equity option is right for you, a financial advisor can help you make an informed decision so you can avoid jeopardizing your finances.