Homeowners across America have access to a record-high of $6.5 trillion dollars in tappable equity, according to the most recent report by data solutions and analytics company, Black Knight, Inc. This figure is up from the $6.2 trillion available to 44.7 million homeowners at the end of last year.
Tappable equity is defined as the sum that homeowners can borrow while still holding on to 20 percent equity of their home’s value. At the same time, mortgage interest rates dropped to a record low of 3.01 percent on July 23, 2020, compared to 3.75 percent at the same time last year, according to Freddie Mac’s Primary Mortgage Market Survey.
If you are among these ranks of home-equity rich but cash-poor homeowners, now may be a good time to leverage your home’s equity and take advantage of low interest rates to make short-term investments, such as home improvements, paying for college, or even investing in a business.
What Is Home Equity?
Home equity, in simple terms, is the difference between your home’s market value and what you still owe on the property. It’s generally spoken of in terms of percentage — the aforementioned difference between your home’s market value and what you still owe on it, divided by the total current market value of your home. Home equity can also be referred to as a number: i.e., the dollar amount of your home’s market value minus its unpaid mortgage amount.
For example, if you own a house worth $350,000 and have $50,000 dollars left to pay on the mortgage, you would have $300,000 dollars in home equity (85 percent equity).
One of the most important measurements of home equity in determining if, and for how much, you qualify for a home equity loan is your “Combined Loan to Value” ratio (CLTV).
Lenders use a home’s CLTV as an important tool to determine the risk of lending to potential borrowers — and how much tappable home equity they have to offer as collateral. To calculate your CLTV, simply calculate the sum of all mortgages secured by your house and divide it by that house’s market-valued price.
Homeowners can typically borrow up to 85 percent CLTV of their home’s equity through a loan before lenders may start charging higher interest rates, depending on their creditworthiness.
This range differs from lender to lender, as each lender evaluates the risk they are willing to take slightly differently based on your credit history, the market value of your home, and how much you earn. The higher your CLTV, the more existing loan you have in relation to the market value of the house, and thus the riskier your home equity loan application appears to a lender (and vice versa).
Going back to the example of a $350,000 house, at this point you have $300,000 of home equity and your CLTV at this point is 14.3 percent ($50,000 divided by $350,000). If we assume that your home equity loan lender has a max of 80 percent CLTV at which they will lend to you at market rates, you can typically borrow money using your equity as collateral — as long as your combined mortgage loan amount on that collateral stays within $280,000 (80 percent of $350,000). But since you still owe $50,000 on your first mortgage, your effective tappable home equity is $230,000 ($280,000 minus $50,000).
“You can use your equity in a home to invest in another property — or really anything you want, unless the lender restricts you to a certain item. However, there is no usual requirement as you’re using your own home’s equity,” states Reef Merhi, loan officer at Texas United Mortgage.
A home equity loan is essentially a type of second-mortgage — assuming your first mortgage has not yet been paid off — wherein you are using your house as collateral for a secured loan.
Secured Loans vs. Unsecured Loans
A secured loan is simply a loan that requires the borrower to use an object of equal or greater value as collateral in case the borrower defaults on their loan. In that case, the lender has the legal right to take possession of the collateral and sell it to recoup the money they lost to the borrower’s default.
The lender is guaranteed to not lose their money invested — or at least as much as they otherwise would — regardless of whether the borrower can make payments or not. Conversely, unsecured loans are simply loans given out on the basis of a borrower’s evaluated creditworthiness without the promise of collateral as a safety net for the lender.
Because home equity loans by definition are secured by the borrower’s house, they often offer homeowners more competitive interest rates than unsecured loans such as personal loans or student loans.
How Can You Leverage Home Equity Toward a Loan?
Home equity loans are most often taken out on homes that are already promised as collateral to their first mortgages — as about 62 percent of all homeowners have yet to pay off their existing mortgages, according to the United States Census Bureau. Lenders of first mortgages have first claim to possession of your house in case of default while home equity lenders have second.
Meaning, if the market value of the house falls so that it’s less than both the first mortgage and second mortgage (your home equity loan), your home equity lender is the one who is most concerned they won’t be paid back. Thus, home equity loans generally offer interest rates lower than unsecured loans but higher than first mortgages.
There are two main types of home equity loans: fixed-rate home equity loans and home equity lines of credit.
What Is a Fixed-Rate Home Equity Loan?
Fixed-rate home equity loans are the most simple to understand: You receive a lump sum cash payment through the loan by using your home as collateral. If you default on your loan, your home may be foreclosed on. Every month you make a fixed payment, interest and principal included, toward repaying your loan for the duration of your term — generally about five to 15 years.
Be warned that interest is charged on the whole sum of the loan starting from when it is disbursed, no matter how slowly or quickly you use up those funds (or for what purpose).
Your interest rate is fixed at the market rate at the time you took out the loan so that the amount you pay every month is the same. This predictable monthly payment amount is an attractive feature of fixed-rate loans because it can be easily factored into your financial planning.
If you have a steady source of income, fixed-rate home equity loans are the best for specific one-time expenditures with a known cost — the most common being home improvements or maintenance.
“If I’m remodeling my kitchen, and I know I’m going to have a fixed cost of $50,000 and I’m more comfortable with a fixed-rate [then] I might go with a home equity loan instead of a home equity line of credit,” says Ian Grove, associate advisor for Robert Green & Company, who previously worked in mortgage banking for 15 years.
What’s more, your home equity loan can help get the most out of your tax refund.
Home equity loan borrowers can deduct the interest paid on a limit of $750,000 of funds used to “buy, build, or substantially improve the taxpayer’s home that secures the [home equity] loan,” according to the IRS. If you are married and filing a separate return, you and your spouse can each deduct the interest on (up to) $375,000 of funds specific to this purpose.
You can renovate your kitchen or install a new security system and write off the interest paid in your tax return — increase your home’s market value and upgrade your quality of life in one fell swoop.
Though the 2017 Tax Cuts and Jobs Act enforced stricter restrictions on the amount and type of interest deductible on spending from your home equity loan ($750,000 down from the previous limit of $1,000,000), it’s still worth filing for any amount of tax deduction. Consider consulting an accountant to fully explore your home improvement deduction options.
What Is a Home Equity Line of Credit?
A home equity line of credit, or HELOC, uses your home to secure a loan just as a fixed-rate home equity loan does but differs in how it disburses funds and its terms of repayment.
“When most people think of a home equity loan, they’re thinking of a HELOC: a home equity line of credit,” says Grove. “It’s easiest to think of the analogy of a credit card that’s secured to your home. You can charge up a credit card [aka withdraw funds from it] and pay it back down, and the interest is going to be based on a revolving amount.”
A HELOC operates similar to a credit card.
It provides you with a revolving line of credit so you can continuously draw funds (and pay them back) up to a certain limit, without reapplying for a loan. HELOC is a variable interest loan with monthly payments that fluctuate according to changes in market interest rates, but are generally lower than fixed-rate home equity loans and often have lower fees.
Imagine you took out a first mortgage of $100,000 on a house valued at $200,000 and were approved for a $100,000 HELOC. You chose to draw $50,000 from the HELOC for kitchen renovations — you now have $150,000 of combined mortgage debt against your house. Grove continues: “You can charge that $50,000 down over time by paying back your HELOC debt, or charge it back up again [by withdrawing more].”
Currently, these market interest rate fluctuations are leaning favorably toward those looking to borrow money, as 90 percent of all homeowners with tappable equity possess first mortgage interest rates above the current market interest rate of 3.01 percent according to Black Knight, Inc.
This means that assuming home market values don’t drastically fall, homeowners rich in equity (those who’ve paid a sizable 50 percent or more of their mortgage) are in a good position to not only borrow at a very low rate, but can also consider refinancing their first mortgage for a lower rate.
One real estate investor, Robert Jenkins, took full advantage of dipping interest rates to start his own property investment business with a home equity line of credit: “My lender paid all my fees and everything associated with it as long as I kept the line open for a few years.”
A HELOC Charges Only for What You Borrow
Once approved for HELOC, a borrower has an “active draw” period of five to 10 years during which you can borrow as much of or as little of that approved loan amount — and you’re charged interest only on what you borrow. Often the minimum payment required during the draw period will be very low, close to interest only — though you can choose to make larger payments so that you can borrow more while staying under your credit limit.
At the end of your active draw period, the line of credit closes and you aren’t able to borrow any more money. You then enter the “repayment” period of 10 to 15 years wherein you make monthly payments that go toward both principal and interest— these payments vary from month to month depending on the market interest rate.
Jenkins’ strategy isn’t for everyone cautions Grove: “While things are cheap now [as interest rates are low], they may not be in a couple years. If you’re wanting to leverage a large amount, you may be in for a surprise when rates eventually begin creeping back up.”
Though interest rates are low now, they may start to increase by the time a HELOC borrower passes into their repayment period in 15 to 30 years’ time. Plan to borrow within your means — or your future-predicted means if you are using a HELOC to invest in your business or other venture with a predicted return higher than your home equity loan rate. Alternatives to home equity loans include personal loans and cash-out refinancing.
Let’s Consider: Fixed-Rate Home Equity Loans vs. HELOC
First, to understand the differences between fixed-rate home equity loans and HELOC, let’s explore what they do.
A fixed-rate home equity loan:
- Disburses a lump sum of cash at the time your loan is approved; this one-time payment is a good source of low-interest cash for many financial situations (e.g., debt consolidation).
- Begins to charge interest as soon as funds are paid to the borrower, no matter how or when you use them.
- Consistent monthly payments: Payments are locked in at the same interest rate (the market interest rate at the time you took out the loan); makes it easy for a borrower to factor payments into their financial budget.
- Best for one-time expenditures with a known cost (ex. home improvement).
Meanwhile, a HELOC loan:
- Allows you to borrow funds, pay them back to replenish the available credit to be drawn on, and borrow more as long as you stay within your credit limit; this flexibility is a convenient source of cash for many situations.
- Charges interest only on funds drawn on, not total credit limit approved.
- Variable monthly payments: Payments fluctuate depending on the market interest rate every month; this interest rate is based on the prime rate, plus a margin as determined by the lender.
- Payments may increase suddenly after the draw period closes and the repayment period begins.
- Depending on the lender, may be eligible to convert some borrowed funds to be repaid in fixed-rate payments (sometimes at a fee).
- Often has lower origination and closing fees than fixed-rate home equity loans.
- Best for situations where you may need to borrow-as-you-go (e.g., paying college tuition every semester).
Now that we understand the differences, it is important to explore which is best suited for different scenarios.
“They serve different purposes for different situations,” states Grove. A fixed-rate home equity loan has slightly higher interest rates than a HELOC and often times more fees, but guarantees the borrower stable repayment conditions where every monthly payment is the same.
“You eliminate the rate fluctuating with the market… but again you lose the flexibility of a HELOC [that lets you borrow as much or as little cash],” Grove continues.
Some HELOCs let you convert part of what you’ve borrowed from variable-rate to fixed-rate during the repayment period so you can get the best of both worlds.
Generally, this process works by first getting approved for a line of credit, with an interest rate that fluctuates with the market interest rate. You then inform your lender of the amount of money borrowed that you want to convert into a fixed-rate based, and come to agreement on the new terms of repayments so that a borrower has the same monthly payments for its duration. This new fixed-rate will be based on the market interest rate at the time of deal.
If this sum that you have negotiated is not the total amount of credit you are allowed to draw, that remaining amount of credit in your HELOC is still available to be drawn on at variable interest rates — which can be later converted to fixed. Many large financial institutions offer such refinancing programs, as well as some credit unions and smaller banks. Shop around your local financial institutions to find the best deal.
Similarities Between All Home Equity Loans:
Both fixed-rate home equity loans and HELOCs may be tax-deductible and offer lower interest rates than unsecured loans such as credit card debt, student loans, or personal loans. Some borrowers choose to “consolidate” their high-interest unsecured debt with a low-interest rate secured loan.
For example, some borrowers choose to pay off credit card debt and personal loans with the funds from a home equity loan — at which point they still owe a monthly payment to only one lender (their home equity loan lender). In this way you are effectively changing your debt obligations to multiple lenders to one lender, and lowering the interest rate at which you pay your debt back. But be cautious: If you default on your home equity loan, your house may be foreclosed on or you may be sued by your lender. In both cases, a default will mean a heavy hit to your credit score.
Though large financial institutions may have more resources to offer better terms, small institutions may be more open to negotiating these terms with individuals in the first place.
When Jenkins was looking to borrow money to invest in real estate, he says, “I found that the large banks were less willing to work with me. They all claimed to be [busy and] couldn’t be flexible in their terms or what they offered. The smaller banks and credit unions were a lot more flexible and gave better terms and rates.”
To conclude, home equity loans are a great way to leverage the untapped equity built up in your home to borrow funds at a low rate.
It’s a worthy consideration to consult with a financial advisor and call up a few banks or credit unions before agreeing to sign. Depending on what you are using your loan for — a one-time expenditure, investment purposes, or even as a source of emergency cash — a fixed-rate home equity loan or a HELOC may offer more competitive interest rates and lower fees for a homeowner looking for a reliable source of quick cash.
*Figures in example rounded to the nearest hundred for simplicity.