As home prices rise to record levels in many parts of the country, the amount of equity homeowners have in their properties is also increasing. Nearly 40 million mortgage holders now have more than 20 percent equity in their homes, according to a recent report from Black Knight Financial Services. That’s the level of equity most lenders require in order to borrow against it.
Tapping into that equity can be tempting, but as the housing bust of mid-2000s taught us, it’s also risky. “Frivolous purchases and things of that nature are great, but you should find a way to do them without borrowing from the equity in your home,” says Keith Gumbinger, vice president of mortgage information web site HSH.com.
In many cases, simply letting home equity continue to build is the best strategy for homeowners, especially those without other significant assets. However, in some instances that home equity can be a tool to help you achieve other long-term financial goals.
There are several ways homeowners can use their home equity, each of which has its benefits and drawbacks. Read on to see which one might make sense for you.
1. Eliminate your PMI.
If you purchased your home with a down payment of less than 20 percent, you’re likely paying private mortgage insurance on top of the interest on your mortgage. As you make payments, however, and the value of your home rises, your equity level may have risen over the 20 percent threshold, making you eligible to eliminate that extra PMI payment.
For conventional mortgages, you’ll simply have to contact your lender and request that they drop the PMI. If you have an FHA loan, however, you’ll have to refinance into a new loan in order to eliminate the PMI.
Pros: Your monthly payment goes down.
Cons: There are no drawbacks to getting rid of PMI on a conventional mortgage, but if you need to do an FHA refinance, you’ll have to pay closing costs and may take a hit on your credit score.
2. Do a cash-out refi.
If you’ve got more than 20 percent equity in your home and a good credit score, you can refinance into a new loan with a larger balance and pocket the difference. It may make sense to use the funds from a cash-out refi to pay off other debt with a higher balance or to invest into improving your home.
Pros: You’ll be able to lock in today’s mortgage rates, which are still low by historic standards.
Cons: In addition to paying fees, you’ll be reducing the equity in your home, so if home prices go down significantly, you could end up under water.
If you’ve recently refinanced or purchased your property you may have an interest rate that’s even lower than those available today. “Anyone who has refinanced in teh last three or four years might have a really good first mortgage rate that they don’t want to refinance out of,” says Kelly Kockos, senior vice president of home equity at Wells Fargo.
3. Take out a HELOC.
A home-equity line of credit give you access to borrow funds as needed on a credit line tied to the equity in your home.
Some homeowners use HELOCs as an emergency fund, or to cover ongoing large expenses such as college tuition or medical bills.
Pros: During the draw period -- typically 10 years -- you’ll pay only interest on the money that you borrow, so payments will be relatively low. “If you are planning to aggressively pay money back, the HELOC is the way to go, and it will give you more flexibility,” says Bijan Golkar, a certified financial planner with FPC Investment Advisory.
Some lenders offer a fully amortizing loan, which will mean higher payment upfront but you won’t see the large jump in payments after the drawdown.
Cons: You’ll be reducing your home equity. Plus, rates on HELOCs are usually variable, so they’re likely to go up in future years.
Take advantage of today’s rising home prices by selling your home for a profit. Then take the equity you’ve built up and use it to buy a smaller house, reducing or eliminating your mortgage in the process. (Home equity can also help you trade up, with the proceeds of your sale going toward a bigger down payment on a more expensive house.)
Homeowners can exclude up to $250,000 in profits ($500,000 for married couples) on the sale of their home from income taxes as long as they’ve lived there for at least two of the past five years. “There are very few others areas where the average U.S. citizen can walk away with up to a half million dollars tax free,” says Bijan Golkar.
Pros: Downsizing to a smaller home or a less expensive area can cut not only your mortgage costs but also all your related housing bills, including utilities, taxes and insurance.
Cons: If you’re in love with your home, moving may not be an option. Plus, it’s a stressful and expensive process.
5. Use a reverse mortgage.
Homeowners 62 and older can use a reverse mortgage to access home equity in either a lump sum, a line of credit or in monthly payments that don’t need to be paid back until either they (or their heirs) sell the property. It may make sense to use the funds from a reverse mortgage to eliminate existing mortgage payments, delay claiming Social Security, or make renovations that will allow you to age in place.
Related: Why Retirees May Want to Take Another Look at Reverse Mortgages
Under new rules, homeowners can only take out up to 60 percent of the total mortgage amount in the first year, and must prove that they’ve got the assets or income to cover the cost of maintenance, taxes and insurance on the property. The amount you can borrow depends on your age, with older borrowers qualifying for larger loans.
Pros: Reverse mortgages may allow “house rich” retirees to remain in their homes while giving them flexibility over when to tap other assets.
Cons: When you eventually move out of your house, there may be little or no equity left, which could restrict your options.