Unlocking Home Equity: Is It Worth The Risk?

Investing in real estate is enticing because of the dream of a passive income stream with strong returns. However, there are often significant barriers in the way, such as the large amount of cash needed for a down payment on a new property. If you're a homeowner, you might already be sitting on the pot of gold you need: your home equity. Home equity is the difference between your home's value and what you still owe on your mortgage. For example, if your home is worth $400,000 and you owe $220,000 on your mortgage, your equity is $180,000. You can use this equity as security with most lenders, borrowing against it to fund investments. However, there are risks involved, and you should carefully consider your financial situation before proceeding.

Home equity loans

To qualify for a home equity loan, you will usually need a good credit score and a FICO score of 660 or higher. Lenders will also consider factors such as your debt-to-income ratio, credit history, and the amount of equity you have in your home.

• Interest rates and repayment terms: Home equity loans typically have fixed interest rates, which can be lower than other types of loans. The regular monthly payments and fixed repayment schedule can make it easier to manage your finances.
• Qualification requirements: To qualify for a home equity loan, you will need a good credit score and a sufficient amount of equity in your home. Lenders will also consider your debt-to-income ratio and credit history.
• Uses: Home equity loans can be useful for funding one-time expenses, such as home improvements, debt consolidation, or education. They can also be used for celebrations, such as weddings, or for investing in other opportunities.
• Risks: It is important to carefully consider the risks before taking out a home equity loan. If you are unable to make the repayments, you could lose your home. Additionally, if you take out more money than you need, you will pay more interest and reduce your equity further.
• Comparison to other options: Home equity loans may offer lower interest rates and more predictable repayment schedules compared to other options, such as personal loans or credit cards. However, it is important to compare the specific terms and conditions of different loan options before making a decision.

Home equity lines of credit (HELOC)

HELOCs are "open-end" lines of credit, which means you can borrow money, pay it off, and borrow again, much like a credit card. The amount you can borrow depends on the equity available in your home, which is the value of your home minus the amount you owe on your mortgage. Lenders will typically allow you to borrow up to 80-85% of your available equity.

The borrowing period of a HELOC is usually 10 years, known as the "draw period", during which you can borrow money and make interest-only payments. After this, the repayment period begins, which is typically 20 years, during which you must pay off the full balance. HELOCs usually have variable interest rates, which means your payments may change from month to month. Some lenders offer the option to convert to a fixed-rate loan, which can protect you from rising interest rates.

While HELOCs can be a useful source of funds, it's important to carefully consider the risks. If you fall behind on payments or can't repay the loan, you could lose your home. Additionally, if the value of your home decreases significantly, your lender may decide to freeze your ability to take out additional credit.

Cash-out refinancing

With a cash-out refinance, you can usually borrow up to 80% of your home's value, though this depends on the property type. For example, for a multifamily home, you can often borrow up to 75%.

A cash-out refinance can be a good option if you want to pay for large-scale home improvements, consolidate debt, or make a large purchase. It can also be a good option if you want to access cash at a lower interest rate than other forms of borrowing, such as credit cards or personal loans.

However, there are some potential disadvantages to consider. A cash-out refinance will increase your loan balance and monthly payments, and you will also need to pay closing costs and fees, which can be significant. Additionally, if you fail to repay the loan, you could lose your home.

• Determine your home equity: Calculate your home equity by subtracting what you still owe on your mortgage from your home's market value.
• Calculate the maximum loan you can take out: This is generally 80% of your home's value.
• Subtract your current mortgage balance: From the new loan amount, subtract what you still owe on your mortgage.
• Estimate your total: In a cash-out refinance, you receive the difference between the balance on your previous mortgage and your new, larger mortgage.
• Shop around for rates from multiple lenders: This will help you get the best deal.
• Weigh the alternatives: Calculate your new monthly mortgage payment and determine if it is affordable for you. If not, you may want to consider another type of loan.
• Submit an application: As with your original mortgage, you will need to go through the appraisal and underwriting process before closing on the loan and accessing your cash.

In summary, a cash-out refinance can be a useful way to access cash at a relatively low interest rate, but it is important to carefully consider the potential risks and disadvantages before proceeding.

Risks of losing your home

Home equity loans can be a risky business, and there is always the possibility of losing your home. Here are some of the risks involved and how to avoid them:

Your Home is on the Line

The most significant risk is that your home is the collateral for the loan. If you default on the loan, the lender can foreclose on your property. This is a worst-case scenario, but it is a possibility, and it is important to understand all the terms and conditions of the loan before signing up. It is also essential to consider your financial situation and whether you can afford the repayments.

Interest Rates can Rise

Some home equity loans have adjustable interest rates, which means your monthly payments could increase if interest rates rise. This can make repayments unaffordable, especially if rates rise quickly.

Payments could Skyrocket

Some loans, such as HELOCs, allow interest-only payments during the draw period. However, this means you are not reducing the principal balance, and when the repayment period begins, your payments will increase significantly.

Your Credit Score can Drop

Taking out a large home equity loan can negatively impact your credit score in the short term, especially if you are already utilising a large amount of your available credit. A lower credit score can make it harder to qualify for other loans or credit cards or increase your interest rate.

Your Debt Load will Increase

Taking on a home equity loan adds to your overall debt burden and increases your debt-to-income ratio. This can make it more difficult to qualify for new loans and impact your ability to manage your finances.

Property Values can Change

If property values fall, you may end up with negative equity, where you owe more than your home is worth. This can impede your ability to sell your home or refinance your mortgage.

Solutions and Precautions

To avoid these risks, it is important to only borrow what you need and ensure you can make the repayments. Fixed-rate loans or loans with lower interest rates can help reduce the risk of rising interest rates. Improving your home with the loan can also increase its value, reducing the risk of negative equity. It is also recommended to seek advice from a financial advisor before taking out a home equity loan.

Tax implications

Home equity is the difference between your home's current value and the amount you owe on your mortgage. There are several ways to access this equity, including home equity loans, home equity lines of credit (HELOCs), and cash-out refinancing. However, there are also potential tax implications that you should be aware of before making any decisions.

One important thing to note is that home equity is usually only taxed when you sell your property, not when you borrow against it. If you sell your primary residence, you may be able to exclude up to a certain amount of the gain from taxes, depending on your filing status. For example, married couples filing jointly may be able to exclude up to $500,000, while single individuals or heads of household may be able to exclude up to $250,000. To qualify for this exclusion, you must typically meet certain eligibility requirements, such as having lived in and owned the home for at least two of the last five years.

When you borrow against your home equity, you may be able to deduct the interest paid on the loan or HELOC from your taxable income. However, the rules around these deductions have changed in recent years. As of 2018, the Tax Cuts and Jobs Act of 2017 allows you to deduct the interest only if you use the funds to "buy, build, or substantially improve" your home. If you use the funds for other purposes, such as paying off credit card debt or taking a vacation, the interest is no longer deductible. Additionally, these new rules only apply to loans and HELOCs taken out after December 15, 2017.

If you sell your home after using home equity financing, the amount you borrowed will need to be repaid from the proceeds of the sale, which can affect your capital gains. If you've owned your home for more than two years and it has been your primary residence for at least two of the past five years, you may be eligible for the home sale exclusion mentioned earlier. However, the amount you borrowed through home equity financing will need to be repaid before calculating any capital gains, which may reduce or eliminate the amount you can exclude.

It's also worth considering the tax implications of different types of loans. For example, cash-out refinancing may result in higher closing costs compared to other options, and you may be considered a riskier borrower as you end up with less equity in your home. On the other hand, refinancing maintains a single mortgage loan on your property, allowing you to deduct mortgage interest from your taxes, up to a certain threshold.

Lastly, if you use home equity financing for home improvements, you may be able to increase your home's basis, which can reduce your capital gains when you sell. Additionally, if you use the funds to buy a rental property, the interest you pay may be deductible as a business expense.

In summary, while accessing home equity can provide a source of funds, it's crucial to understand the associated tax implications. Consulting with a tax professional can help you make informed decisions and ensure you don't end up with unexpected tax burdens.

Frequently asked questions