16 Jun Tapping into Your Home’s Equity
For most Americans, their home is a significant portion of their net worth and one of their largest single investments. However, as an asset class real estate is relatively illiquid. After all, you cannot sell a bathroom when you need some additional cash. Fortunately, there are a few options available to tap into the equity in your home if needed. The best option for you is dependent on your circumstances and needs; a CERTIFIED FINANCIAL PLANNER™ can assist you in selecting your optimal strategy. Here are the pros and cons of some of the most common methods:
Over time, as the value of your home increases, you may find that a larger and larger percentage of your net worth is in your home. Houses that may have cost $250,000 at purchase 20 years ago, may be worth $1,000,000 in today’s dollars. The 4-bedroom home that you needed when the children were little, may be oversized now that you are empty nesters. Larger homes can have significant carrying costs (maintenance, utilities, taxes) which can become a drain for retirees. In our practice, we have seen clients that are “house poor” – spending an overly large percentage maintaining and paying for a home that they no longer need. The solution: sell and downsize. A right-sized home can reduce annual expenses and allow you to add cash to your portfolio. The cons: real estate fees are generally 6% of the sales price, there are moving expenses and you may have costs to get your home ready to market.
Home Equity Loan
If you have sufficient equity in your house, you may be eligible for a home equity loan. Traditional home equity loans are a second mortgage on your property and are issued for a set cash amount. They are best used for home improvement projects wherein the money is used to further increase the value of the property: kitchen renovations, adding a bathroom, improving energy efficiency, or adding a deck. Homeowners also use them to fund a specific immediate need, such as large medical expenses or college costs. The cons: just like a mortgage, there are closing costs and the interest rate may be higher than a first mortgage. Payments on the full amortized amount of the loan are due when the funds are disbursed so your monthly debt increases.
Home Equity Line of Credit (HELOC)
One of the most flexible options is a HELOC. A Home Equity Line of Credit essentially gives you a checkbook to tap into the equity in your home. Of course, you must have sufficient equity and the amount is capped. However, HELOCs can provide liquidity and access to capital when needed and closing costs are minimal. Suddenly need a roof repair? You can pay for it with a HELOC check. The terms of repayment are generous – often interest-only for a period of time (10 years is common) before the principal amount needs to be repaid. Pandemic note- most banks have raised their requirements for HELOCs, and they may currently be difficult to get. The cons: the balance can build over time if used as an emergency fund and the payments can be steep when you enter the repayment period.
With mortgage rates at new lows, the time may be right to consider a cash-out refinancing mortgage. Under this scenario, you pay off your first mortgage (presumably at a higher interest rate) and get additional cash from the equity in your home. Cash-out refinancing can be used to facilitate the purchase of a second home or pay off higher interest rate debt from credit cards or student loans. The cons: you are reducing the equity in your home and adding to your monthly debt payments. If used to pay for a depreciable item (like a car) or to fund recreational expenses (like a vacation) then your net worth will decline.
Also known as a Home Equity Conversion Mortgage (HECM), this is an option for those over the age of 62 who reside in their home as a primary residence and have significant equity in the property. Unlike the other types of loans described, the HECM allows the homeowner to withdraw a portion of the equity with no repayment until they die, move, or sell their home. Reverse mortgages work best for clients who want to stay in their homes, have substantial home equity but are experiencing cash flow issues. The proceeds can be used for living expenses, debt repayment, healthcare, and more. The amount that can be borrowed varies with the age of the homeowner and the value of the house. Generally, the older you are, the lower the interest rate and the more your property is worth, the larger the principal limit of the loan. The cons: the homeowner must maintain the house and continue to pay the property taxes and insurance. The fees and closing costs are extremely high and the interest continues to accrue for the life of the loan eating into the remaining equity in the home.
Although many options exist, we suggest all clients proceed with caution when using their home equity to meet financial obligations. Except for the outright sale of the home, in all the other options discussed, you are pledging your home as collateral for the access to cash. Be sure that you understand the risks.