Tapping into the equity in a home to obtain cash is very popular and very common. The equity in a home is the difference between the home's value and the amount owed on the home (the mortgage balance). Depending on how long the home owner has been paying their mortgage, and the strength of the housing market, a home's equity can be a very significant amount of money.
Reasons to Obtain a Home Equity Loan
There are many reasons why a home owner may want to tap into the equity in their home to obtain cash. Some of the more popular reasons include:
There are many different ways for a home owner to tap into the equity of their home, including cash-out refinancing, home equity loans, home equity lines of credit, and even reverse mortgages. All of these are described in detail below.
Cash-out refinancing is one popular way of obtaining cash from the equity in your home. In a cash-out refinance, the home owner refinances their home for an amount that is larger than the balance on their existing mortgage. The difference, or excess loan amount, is paid to the homeowner as cash. For example, a homeowner with a home valued at $250,000 and an existing mortgage balance of $150,000 may refinance their home for $200,000. In this transaction, after the old loan was paid off and the new loan is put in place, the homeowner would walk away with $50,000.
A second mortgage, or second loan, is an additional mortgage that a homeowner takes out on their home in addition to their first or primary mortgage. It is referred to as a "second" mortgage because it is in a second lien position behind the first. This means that in a foreclosure situation, the proceeds of the sale of the home would go to pay off the primary mortgage first, followed by the second mortgage. It is also possible to have third, and fourth mortgages on a home, the number referring to their relative lien position.
The term of a second mortgage is typically not as long as the primary mortgage (which is usually 30 years). Second mortgage terms may, however, extend as long as 15 or 20 years.
Second mortgages may have either fixed or adjustable interest rates. Some lenders may charge fees or points to lend the homeowner money through a second mortgage.
Home Equity Line of Credit
A home equity line of credit, also referred to as a HELOC, is usually a second mortgage. Unlike a second loan, with a HELOC a borrower receives a line of credit versus an up front cash pay out. The borrower is free to "draw upon" the line of credit as they need cash. HELOCs are set up for a maximum draw amount, an amount that the homeowner may not exceed. Until the homeowner uses the line of credit, they do not have to make any payments.
As a homeowner uses their line of credit, the balance increases. This is similar to using a credit card. As the balance increase interest accrues on a daily basis on the outstanding balance. Interest rates on home equity lines of credit are adjustable. Their interest rates are usually tied to the prime interest rate.
Home equity lines have a draw period, the period of time during which the homeowner may draw against the line. Draw periods are usually five to ten years in length. During the draw period the homeowner is only obligated to pay interest. HELOCs also have a payback period. Repayment periods typically run ten to twenty years. During that time period the home owner must pay back the balance of the loan at the rate of the balance divided by the number of months in the payback period. They also must pay accrued interest on a monthly basis.
Some home equity lines are due in full at the end of their draw period. With these loans, the homeowner must either pay the balance, or refinance the loan.
The Risks of Tapping into a Home's Equity
There is risk to taking equity out of your home. Using the equity in your home to obtain cash for other uses works well as long as the housing market is strong and the value of your home continues to grow. If the housing market were to downturn and house prices decline, a home owner could end up in a situation where their home is worth less than the outstanding loans on the home. This can become a significant problem if the homeowner must sell their house for any reason. After selling their home they would still owe one or more lenders money.
A reverse mortgage, also referred to as a reverse annuity mortgage, or a home equity conversion mortgage (HECM), is a special case for individuals 62 years of age or older. A reverse mortgage is a way for homeowners to tap into the equity of their home to obtain cash for living expenses or other uses. With a reverse mortgage, cash is distributed tax free as a lump sum payment and/or a monthly payment.
Unlike the other home equity loans described in this article, with a reverse mortgage, the borrower does not have to pay anything back until the loan comes due. With a reverse mortgage the loan typically comes due and must be paid back with the death of the borrowers, or the sale of the home.
The Downside to a Reverse Mortgage
A reverse mortgage may not exceed the value of a homeowner's home. A lender may only get paid back from the proceeds of the sale of the home. They have no recourse other than the home's value and may not go after heirs's assets if the home does not cover the outstanding balance of the loan. The main downside of a reverse mortgage is that as the loan balance increases over time, the homeowner's estate shrinks, and there is less to be left to their heirs.