As you pay down your mortgage or the value of your home increases, you build up what’s known as home equity. Essentially, this is the difference between what your home is worth and the amount you still owe on your mortgage. For example, if your home would currently sell for $750,000 and the remaining balance on your mortgage is $600,000, then you have built up $150,000 in home equity.
If you’re eligible, you can borrow money secured against that equity through one of many second mortgage options, or by borrowing against the home through some type of loan.
Typically, interest rates on loans secured against homes are much lower than other types of loans or other credit products. That’s why home equity is one of the biggest perks of homeownership.
The additional funds can be used to consolidate debt, make a big purchase, maximize your investments, or worst-case, manage unexpected expenses or emergencies, such as a job loss.
If you’re considering borrowing against your home, it’s important to weigh the risks as well as the benefits. The one you choose will depend on you and your situation.
Let’s walk through four of the most popular ways to reap the benefits of your home equity below.
If you’ve built up extra equity in your home, you can apply for a new mortgage to pay off your original one and use the difference for large expenses, such as home renovations or your kid’s tuition fees. This is known as a mortgage refinance.
You can borrow up to 80% of the appraised value of your home, minus the balance of your existing mortgage. To determine if you qualify, the lender will look at your monthly income, level of debt, and credit report.
There are some disadvantages to consider when it comes to refinancing a mortgage. There may be a large penalty to pay your lender if you break your mortgage term early, and if you’re switching lenders, you may need to pay a fee to discharge your mortgage from your current lender. If you want to switch lenders and your new lender is a bank, you may need to re-qualify for the stress test. And if you switch from a fixed-rate mortgage to a variable-rate mortgage, you may deal with rising interest rates and higher monthly payments in the future.
Paying those fees is only worth it if you’re going to save thousands of dollars in interest by switching to a lower mortgage rate.
Home equity line of credit (HELOC)
Another way to tap into the equity you’ve accumulated is through a home equity line of credit (HELOC). A HELOC enables you to access 65% to 80% of your home’s appraised value. Much like a regular line of credit, it allows you to withdraw money as you need, up to the limit. Some HELOCs even come with a debit card or cheques so that you can access funds easily.
One benefit of a HELOC is that you can access funds whenever you need them. There is also no need to apply for a new loan every time you need extra cash. You may prefer this option if you don’t know exactly how much money you’ll need or you need to access money quickly for the lowest monthly payment. Another benefit is that you may be able to negotiate with a lender to pay your administrative fees, such as appraisal fees, title search, title insurance, and legal fees.
Unlike conventional mortgages, HELOCs allow consumers to make interest-only payments. There are, however, risks involved with this. Firstly, the interest rate on a HELOC is variable, which means your payment each month fluctuates depending on the amount you borrow and how market interest rates go up or down. Another disadvantage is that your lender can lower the credit limit or require you to repay your HELOC (even the full amount, whether you’ve used it all or not) at any time. Your lender can also take possession of your home if you miss payments.
While a HELOC is one of the most flexible options on this list, it requires a lot of self-discipline to pay off.
Home equity loan
Another way to access your home equity is by getting a home equity loan. With this option, you can also borrow up to 80% of your home’s value, but unlike a HELOC, the funds are disbursed in one lump sum and paid back over time in equal payments.
If you take out a home equity loan, you must make regular payments, which include a fixed interest rate on the entire amount.
The advantages of a home equity loan include predictable monthly payments, access to capital to fund large expenses, and a fixed interest rate. It’s also a way to consolidate debt and lower interest rates on existing debt.
However, there are disadvantages to be aware of. Similar to a traditional loan, your home is at risk of repossession if you default on your payments. There are also costs and fees to consider. And although the interest rates tend to be lower than rates on other loan types, the rates are higher when compared to HELOCs.
A reverse mortgage is designed for eligible seniors aged 55 and up.
You can borrow up to 55% of the current value of your home but you must first pay off at least 50% of your mortgage.
Your application must include all the individuals listed on your home’s title and all these individuals must be at least 55 years old to qualify.
The maximum amount you’re able to borrow will depend on your age, your home’s appraised value, and your lender.
The benefit of this tax-free loan is that you don’t need to make any payments on a reverse mortgage until you move out of your home, sell it, or the last borrower dies.
A reverse mortgage is usually an attractive alternative source of income for retirees because there is no income verification required, which can be especially useful for retirees. However, the longer you go without making payments, the more interest you will owe. The disadvantage of this is that you may have less equity in your home at the end of your loan term.
There are some disadvantages to be aware of with this option, too. For instance, the costs associated with a reverse mortgage tend to be higher than a traditional mortgage or other types of loans, such as a personal loan or a credit card. Fees include a home appraisal fee, setup fee, a prepayment penalty if you pay off your reverse mortgage before it is due, legal fees for closing costs, and/or independent legal advice. Keep in mind that your estate has to repay the loan and interest within a set period of time after you die. If your estate fails to repay the funds, they could end up losing the house.
As you can see, each of these options has its own benefits and drawbacks. You’ll have to call your lender or a financial advisor to figure out the best way to leverage your home equity.