3 Creative ways to Leverage your Home’s Equity

Introduction

At the end of my first post, I mentioned how I used leverage from my first house to buy my second and invest a bit too. This method of leveraging helped me scale my portfolio over time. In simple terms, leverage is the use of various financial instruments or borrowed capital, or debt, to increase the potential return of an investment. While I have found leveraging to be a helpful tool, it can be a double-edged sword as the risk increases with an increase in potential returns. You should always be cognizant of the risk involved with taking on more debt and make sure that there is enough spread and cash flow from a rental, or that you are able to make the additional monthly payment from your income to play it safe. From my first house, I used debt to grow my net worth and generated returns. In this post I will teach how to leverage equity along with some other strategies that can be used with your property’s’ equity.

For those that find the term equity new to their vocabulary, hang tight. Equity is the difference between your home’s value and what you still owe on the mortgage. For example, let’s say your home is worth $600,000 and you still owe and have a balance of $480,000 on your mortgage; your equity in that house is $120,000. This equity is yours to use but you must access it first. There is a saying, “you can’t eat equity”. This is very true. You can have thousands of dollars in equity but it doesn’t really do you much if it is tied up in your house. It should be put to work.

There are three main ways to take this equity out and put it to use. Each one has its benefits and drawbacks so make sure you consider each one if you decide to take equity out of your home. With each one of these methods, your home is used as collateral. It is the security to protect the lender if you end up defaulting on your loan. This means that these methods come with that additional risk.

All three of these methods are ways to put your money into a plethora of needs. It can finance home-improvement projects, consolidate what you own on credit cards or other high interest rate debts into a single loan, cover emergency expenses, help pay for education tuition and fees, virtually any purpose.

Option 1: Home Equity Loan

This is the loan that I used on my first house to pull money out and reinvest. With this type of loan, you apply for the amount that you need, and you receive it in a lump sum. This money can be used for anything that you would like and there are no restrictions. Most of these loans are with a fixed interest rate and the monthly payment is the interest on the loan plus a portion of the loan principle. This is a similar structure to your primary mortgage and is often referred to as a second mortgage. This is because you have another loan payment to make on top of your primary mortgage. This repayment amount will remain consistent throughout the term of your loan which can be 10 to 30 years based on your lender.

Depending on your lender, a home equity loan allows you to borrow around 80-90% of your home’s value minus what you owe on your mortgage. An example of this would be a home worth $350,000, and a mortgage balance of $200,000. Your lender will allow you to borrow up to 85% of your home’s value. Multiplying your home’s value of $350,000 by the percentage you can borrow (85% or .85) gives you a maximum of $297,500 in value that could be borrowed. If you subtract the amount remaining on your mortgage ($200,000), you’ll get the approximate sum you can borrow as a home equity loan. In this case, $97,500.

For a home equity loan there are some requirements. These vary by lender but here is an idea of what you’ll likely need to get approved. Home equity of at least 20% is a common requirement so that there is money to pull out without adding too much risk to the lender. A credit score of 620 or higher is also needed to show you can repay debt but some lenders will allow a lower credit at the cost of a higher interest rate and fees. A debt-to-income ratio of around 43% or lower is also needed but that may vary depending on your lender so be sure to shop around.

Some of the pros and cons of a home equity loan are stated below.

Pros:

-Fixed rates provide predictable payments.

-Lower interest rate than with a personal loan or credit card.

-If your current mortgage rate is low, you don’t have to give that up.

-If you use the loan for home improvements or renovation, the interest may be deductible on your taxes.

Cons:

-Less flexible than a home equity line of credit.

-You’ll pay interest on the entire loan amount, even if you’re using it incrementally, such as for an ongoing remodeling project.

-As with any loan secured by your house, missed or late payments can put your home in jeopardy and severely hurt your credit.

-If you decide to sell your home before you’ve finished paying back the loan, the balance of your home equity loan will be due.

Option 2: HELOC

Another option to take equity out of your home is to use a home equity line of credit or a HELOC. A HELOC uses the equity in your home as a credit line. This is the same concept as a credit card and using that line of credit to make purchases. The credit amount is secured by your home and gives you a revolving credit line where you can draw money as you need. This often has lower interest rates than most other types of loans including home equity loans. HELOC’s do have a variable interest rate, similar to adjustable-rate loans. This means that your interest rate increases or decreases over the loan term as the market fluctuates, as does your monthly payments. Just like home equity loans though, the interest may be tax deductible. Tax law states that interest on loans used to “buy, build, or substantially improve” a home may be deducted.

As stated already, a HELOC works like a credit card. You are borrowing against available equity in your home and the house is used as collateral for the line of credit. As you repay your outstanding balance, the amount of available credit is replenished just like a credit card. There is a draw period of typically 10 years where you can borrow and use this line of credit and at the end of that time, the repayment period of typically 20 years begins.

With a HELOC, you can typically borrow up to around 85% of the value of your home minus the amount you owe just like a home equity loan. The fund limit that you get can be used if and when you need it and you only pay interest on the money that you use.

Some pros and cons of a HELOC are stated below.

Pros:

-Lower rates than credit cards and personal loans and even home equity loans.

-Only pay for the amount that you spend in the credit line

-Use the money for anything and larger amounts than credit cards or personal loans.

Cons:

-Variable interest rate (even though they are less than other loan options they can still rise)

-May have a minimum withdraw amount, fee and closing costs,

-You risk losing your house if you default

Option 3: Cash-out Refinance

The third option if you want to use the equity in your home is a cash out mortgage refinance, also referred to as a cash out refi. A cash out refi involves taking out a home loan that is larger than what you own on your current mortgage and getting the difference in cash. While a home equity loan enables you to take out a second mortgage on your property, cash out refinances replace your primary mortgage. Instead of obtaining a separate loan, the remaining balance of your primary mortgage is paid off and rolled into a new mortgage that has a new term and interest rate. With a cash out refi, you received funds for the equity in your home, just as you would with a home equity loan. Unlike a home equity loan, you only have one monthly mortgage payment. The interest rates in a cash out refi are normally lower than with a home equity loan. The reason for this difference in interest rates has to do with the order in which lenders are paid in the case of defaults and foreclosures. Home equity loan rates are generally higher because second mortgages are only paid back after the primary mortgages have been so there is a higher risk that the sale price will be too low for the lender to recoup their costs.

When performing a cash out refi, you’re able to lock in a new interest rate so they are an extremely beneficial option for those who purchased their home when interest rates were high. With a cash out refi, you can get cash upfront while also lowering your monthly mortgage payment if rates have dropped since you bought your home. Because of this, a cash out refi is a good option when interest rates are low or if you’re already planning to refinance for other reasons.

In Conclusion

If you have built enough equity in your home, it might be a good move for you to reinvest that equity into an income producing asset. In my next post, I’ll go into detail about the second property that I purchased through leveraging the home equity loan of my first property.