You pull equity out of your home by borrowing using your house as collateral. There are several ways to get money out of your home. You can refinance, get a second mortgage or get a home equity line of credit (HELOC).
- You may use the money for almost anything
- Banks usually let you borrow up to 80% of your property’s value
- There are strategies that let you use equity to pay off your mortgage
- You might cash-out money from your home to buy another property
You can use the money that you have built-in your property for a variety of reasons. Be careful how you use the value you have in your property, though. Remember that it is your home, and if you borrow more than you can pay back you will lose the roof over your head.
Cash Out Equity
The two most common ways to pull out equity in your home is with a refinance or HELOC. Each has pros and cons that you should consider before you decide.
- A refinance replaces your existing mortgage with a new one
- HELOCs do not replace your existing loan but add another loan to your debt
Make sure that you have a good reason to borrow more money against your house. Remember that with either of these you use your house as collateral. If you fail to pay them back, you will lose your home.1
Refinance to Pull out Equity
When you refinance your house to pull out equity, you replace the existing mortgage with another. Some important things to remember about this type of loan are:
- It pays you a lump sum
- You receive the net proceeds after the bank pays your first mortgage
- Interest rates may be fixed or adjustable
- Closing costs are like your original mortgage
Only refinance your home if you need a lot of money at one time, usually an emergency. Another reason people do this is to consolidate debt because they pay a lower interest rate. However, remember that you will have considerable closing costs. It’s not cheap to refinance a house.
HELOC to Pull Out Equity
A HELOC is a line of credit that can use to pull out equity in your home. It is easier and cheaper than refinancing.
- You usually take this out in addition to your mortgage, and it has its own terms and repayment schedule
- You may withdraw funds from your available credit line as you need the money
- It has a variable interest rate that changes in conjunction with an index
- It has relatively small closing costs (and sometimes none)
These loans have caps on how much you may borrow. They have one period where you can borrow, and when that closes, they have a repayment period that typically lasts 20 years. People use these to consolidate debt or as an emergency fund. Whatever the reason, be careful about borrowing against your home.
Take Out Equity Without Refinancing
You can take equity from your home without refinancing. There are two ways to cash out money from your home.
- A home equity loan, also called a second mortgage, is more structured
- HELOC is more flexible
Second mortgages work like your primary home loan, but it will have a higher interest rate. You may draw on HELOCs as you need. They are always variable rate tied to an index.2
How Much Equity Can I Borrow?
Banks let you borrow up to 80% of your home’s value. That means that if you have the first mortgage, and you owe 80% or more of the house’s value you cannot get a home equity loan. However, you may be able to refinance up 97% of your home’s value with an FHA loan or if you pay PMI. To understand just how much you can borrow:
- Calculate equity – Find out the difference between your property’s market value and how much you owe
- Know your Loan to Value (LTV) limit – This depends on your lender, type of loan, and specifics about the property
- Learn your debt-to-income ratio – Banks use this to determine your credit risk.
Refinancing is another option if you don’t meet the requirements for an equity loan. Banks will refinance for a greater percentage of debt, looser LTV requirements, and if you have more debt because it will be the primary mortgage on your house. Second mortgages of any kind are always harder to get.3
When You Pull Out Equity
What happens when you take out an equity loan depends on what kind of loan you have. Three types of loans are common, and you should be careful about how you use each.
- Refinance – Pay off large, often unexpected, one-time expenses
- Second mortgage – Consolidate loan and/or pay off high-interest loans
- HELOC – Use as an emergency fund
All of these are good options for consolidating or eliminating debt. Refinances and second mortgages pay you a lump sum. Therefore, they are best suited for making a single payment. On the other hand, you should use a HELOC differently. You might use it to pay down high-interest debt, but you may also use it as a source for emergency funds.
Using Equity to Pay Off a Mortgage
You can use equity to pay off your mortgage. There are several variations on the strategy of using a HELOC to pay down your mortgage faster. All of them rely on the prospect that you have more income than you spend each month. For a variety of reasons, we don’t recommend using you any of these.
- The strategy is too complex
- It requires more discipline than most people have
- You’re replacing one type of debt for another
- HELOCs have variable rates
- Your bank can freeze the line
The bottom line is there are better ways to do the same thing. Almost always, the simplest way is best, and the simplest way is to make extra principal payments. If you have enough extra income to use this strategy you have enough to make extra payments directly.4
Mortgage One House to Buy Another
You can mortgage your house to buy another property. You have three options to do this. Each has pros and cons.
- Refinance – Restructuring your loan on your primary residence will have a lower interest rate; you will also incur closing costs and put more debt on your home.
- Second mortgage – This is a subordinate loan on your primary residence with large closing costs
- HELOC – This has much lower costs to set up, but the rate is variable
You will get a lower interest rate by borrowing against your primary residence, so it makes a lot of sense to use this strategy. If you have enough income to pay for two properties, then we believe you should put the bulk of the debt on your primary residence to take advantage of lower interest rates. Please be very careful, though, that you aren’t taking on more debt than you can handle. Make sure that you run all the numbers and are absolutely sure that you can afford a second home.