How does using your home equity work

There are several ways you can get access to your home equity, whether through a cash-out refinance or home equity loan, home equity line of credit or reverse mortgage.

Cash-Out Refinance

A cash-out refinance allows you to take out your equity by getting a new mortgage with a higher loan amount. You replace your current mortgage with a bigger one and get the difference in cash. Like with any refinance, your new mortgage pays off your old one, so you just have one monthly mortgage payment. It generally takes between 30 and 45 days to refinance.

When you do a cash-out refinance, you usually need to leave some equity in the home. The amount you’ll have to leave in depends on the type of loan you’re seeking, but you should expect to leave about 20% equity in the home. 

For example, let’s say your home is worth $200,000 and you owe $100,000 on your mortgage. To take cash out, you need to leave 20% equity ($40,000) in the home. If you were to refinance your home with a new loan amount of $160,000, you’d get to pocket $60,000, minus closing costs and fees.

You can use the money from a cash-out refinance for anything you want. The money is tax-free, and there are no restrictions on how you can use it.

Home Equity Loan

A home equity loan is a second mortgage on your home. It doesn’t replace your current mortgage; instead, it’s a second mortgage that requires a separate payment. For this reason, home equity loans tend to have higher interest rates than first mortgages.

Like a cash-out refinance, a home equity loan is a secured loan that uses your home equity as collateral. This gives you access to lower interest rates than unsecured loans, like personal loans.

Once you close on your home equity loan, you’ll receive a lump sum payment from your lender, which you’ll make payments on over a predefined loan term.

Lenders rarely allow you to borrow 100% of your home’s equity for a home equity loan. The maximum amount you can borrow varies depending on the lender but is typically between 75% and 90% of the value of the home. Rocket Mortgage® is now offering The Home Equity Loan, which is available for primary and secondary homes.

Home Equity Line Of Credit (HELOC)

A home equity line of credit (HELOC) is also a second mortgage on your home. The main difference is that a HELOC gives you a line of credit that you can draw from when you need it. The credit limit corresponds to the amount of equity you have in your home.

You can withdraw HELOC funds at any time during the draw period defined by your lender. Most draw periods are between 5 and 25 years. HELOCs may have a minimum monthly payment due (similar to a credit card), or you may need to pay off the accrued interest each month. At the end of the draw period, you’ll need to repay the full amount borrowed.

Interest rates on HELOCs are usually based on an index instead of a fixed rate. There are usually no limits on the amount the interest can increase each period. If you choose a HELOC versus a cash-out refinance, make sure you carefully monitor your spending and interest accumulation. Rocket Mortgage does not offer home equity lines of credit at this time.

Reverse Mortgage

If you’re over the age of 62 and would like to boost your retirement savings, you may want to consider a reverse mortgage. There’s no monthly mortgage payment with a reverse mortgage, though you must still pay taxes and insurance.

With a reverse mortgage, your loan amount is based on the amount of equity you have in your home. If you have an existing mortgage, the proceeds of the loan are used to pay that off. The rest is available for you to use as you see fit.

There are different types of reverse mortgages that offer the proceeds from a reverse mortgage  in several ways:

• As a lump sum of cash at closing, as with a proprietary reverse mortgage
• Through monthly payments that you’ll get as long as you live in your home
• Through monthly payments for a fixed period of time
• Through a line of credit that you can draw on at any time

A reverse mortgage can be a good choice for homeowners who plan to stay in their home indefinitely and aren’t worried about leaving an inheritance. It can give you cash in retirement if you don’t have anywhere else to get it. Rocket Mortgage does not offer reverse mortgages at this time.

One of the benefits of buying a home is that you can build equity in it and tap into that equity to pay for a major kitchen remodel, eliminate your high-interest credit card debt or even help cover your children’s college tuition.

But what exactly is equity, and how can you use it? Here’s a quick guide to the basics of how home equity works and why it’s so valuable.

What Is Home Equity?

Equity is the difference between what you owe on your mortgage and what your home is currently worth. If you owe $150,000 on your mortgage loan and your home is worth $200,000, you have $50,000 of equity in your home.

Your equity can increase in two ways. As you pay down your mortgage, the amount of equity in your home will rise. Your equity will also increase if the value of your home jumps.

Your equity can fall, too, if your home’s value drops at a rate faster than the speed at which you’re paying down your mortgage’s principal balance.

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How Does Home Equity Work?

Here’s an example of how equity can change over time.

Say you buy a house for $200,000. You might come up with a down payment of 10% of your home’s purchase price – which would be $20,000. Your lender will then provide you with a mortgage loan of $180,000.

If your home is worth that $200,000 sales price, you now have $20,000 of equity, or $200,000 minus $180,000.

Jump ahead 2 years. You’ve been making your mortgage payments on time, and you might now owe $170,000 on your mortgage. Maybe your home’s value has jumped too during this time to $210,000.

You now have $40,000 in equity, or $210,000 minus $170,000.

Your home’s value could work against you, too. Say you’ve paid down your mortgage loan to that same $170,000, but your home’s value has actually dipped to $195,000. Now you have $25,000 in equity, or $195,000 minus $170,000.

To determine your equity at any one time, you’ll need to know the value of your home.

Only a real estate appraiser can give an official valuation of what your home is worth in today’s market. You can, though, estimate your home’s value by looking at comparable home sales in your area or by checking with online real estate sales that provide their own home value estimates.

Just remember that these estimates aren’t always accurate and exist just to give you a rough idea of your home’s current worth.

How To Build Home Equity

Fortunately, there are a number of ways you can build equity in your home.

Make A Big Down Payment

The fastest way to build equity is to come up with a large down payment. The bigger your down payment, the more equity you’ll immediately have in your home.

Say you buy your home for $180,000. If you put down $5,000, you’ll owe $175,000 on your mortgage. That leaves you with $5,000 in equity. If you put down $20,000, you’ll owe $160,000 on a home worth $180,000. That $20,000 in equity is far more impressive than $5,000.

Figuring out how much you can use toward your down payment is a big step in understanding how you’ll build equity in your home. Getting preapproved for a mortgage before you make an offer will help you understand how much of your savings you’ll have to use toward your down payment.

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Focus On Paying Off Your Mortgage

A portion of each mortgage payment you make will go toward the principal balance of your home loan. The rest will usually go toward paying interest, property taxes and homeowners insurance.

When you first start making your mortgage payments, a smaller amount will go toward reducing your principal balance and more will go toward your interest. The good news, though, is that the longer you have your mortgage, the more money will go toward reducing your principal balance and building your equity.

But it’s important to be aware that some loans don’t operate this way.

If you take out an interest-only or other non-amortizing mortgage, you won’t reduce your principal balance or build equity. Instead, your payments will only go toward paying your interest, property taxes and insurance. Eventually, you’ll need to pay a lump sum to pay off your loan principal balance.

Pay More Than The Minimum

If you want to build equity more quickly, you can always pay more than your required payment each month. Making an extra payment each year on your own or through biweekly payments or even paying an extra $100 a month can help you chip away at your loan’s principal balance as well as help homeowners increase their home equity at a faster rate.

Stay In Your Home 5 Years Or More

You’ll build equity if your home increases in value. Of course, no home is guaranteed to see its value jump, but you will increase your odds if you stay in your residence for a greater number of years.

Plan on staying in your home for 5 years or more if you want to see its value jump enough to give you an equity boost.

Renovate And Add Curb Appeal

You can help boost your home’s value by adding an extra bedroom, renovating that old kitchen or adding a master bathroom. Investing in landscaping and giving your home curb appeal can help too.

How To Use Home Equity

Equity is an important financial tool and one of the greatest financial benefits of owning a home.

You can tap into this equity when you sell your current home and move up to a larger, more expensive one. You can also use that equity to pay for major home improvements, help consolidate other debts or plan for your retirement.

Using Equity To Buy A New Home

Perhaps you've lived in your home for 7, 8 or 9 years. Maybe your family continues to grow. Or maybe your job is taking you to a new city. Whatever the reason, you're ready to sell your home and find a new place to live.

Equity can be your friend as you make this move.

Let’s say the home you’re selling is worth $220,000, and you've built $70,000 worth of equity in it. If you sell your home for what it’s worth, you'll leave the closing table with a profit. You probably won’t get the entire $70,000 in equity you’ve built because of such fees as your real estate agent’s commission and some mortgage closing costs. But you’ll end up with a solid profit that you can then use for a large down payment on your next home.

With this big down payment, you may be able to get into a larger, more expensive home because your mortgage will be smaller. And with a smaller mortgage, your monthly payment will be lower, too.

If your down payment is big enough, your monthly mortgage payment might be smaller than it was with the residence you sold, even if that home was smaller and less expensive.

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Using Equity For Your Retirement

If you're 62 or older and considering retirement, you might explore a reverse mortgage1. With a reverse mortgage, you’ll stop making your monthly mortgage payments and will instead receive money based on the equity in your home.

How much you can borrow depends on your age and how much equity you have in your home as well as current interest rates.

You can elect to receive your proceeds in one lump sum, regular monthly payments or a line of credit. Any combination of the three payment types is also possible.

You don't pay back your loan unless you sell your home, move out for more than 6 months out of the year or pass away. If you sell the property, you would then use the profits from your home sale to pay back the loan.

If you pass away, your heirs have options. They can choose to sell the home (keeping any profits after the loan is paid off), refinance into a regular forward mortgage or walk away and let the lender sell the home. A reverse mortgage is a nonrecourse loan, meaning your heirs won’t be forced to pay back anything more than what they can get from the sale of the home.

Rocket Mortgage® doesn’t offer reverse mortgages at this time.

Options For Borrowing Against Home Equity

There are three main ways you can borrow against your home’s equity: a home equity loan, a home equity line of credit or a cash-out refinance.

Using equity is a smart way to borrow money because home equity money comes with lower interest rates. If you instead turned to personal loans or credit cards, the interest you’d pay on the money you borrowed would be far higher.

There is a potential danger to home equity lending, though. If you fail to make your payments on time, your lender could take your home through the foreclosure process. This can’t happen when you take out a personal loan or when you charge purchases with your credit cards.

Cash-Out Refinance

In a cash-out refinance, you refinance for more than what you owe on your mortgage. You again receive this extra money in cash that you can use however you want.

Say you owe $180,000 on your mortgage. You can refinance for $220,000 and then take the extra $40,000 in cash. You will repay the $220,000 total in monthly payments, with interest. How much extra you can include in your cash-out refinance depends on the equity in your home.

With a cash-out refinance, you’ll be borrowing against the equity in your home rather than relying on your credit. This can give you access to greater funds typically with lower interest rates than other types of financing. You typically have to leave at least 20% equity in your home after doing your cash out refinance, so be sure you have enough equity to accomplish your goals.

Once you refinance, you’ll continue to have a single mortgage.

Home Equity Loan

While a cash-out refinance loan effectively replaces your original mortgage, a home equity loan works like a second mortgage.

Say you have $50,000 in equity. You might qualify for a home equity loan of $40,000. Once the loan closes, your lender will lend this $40,000 in a single payment. You can then use this money however you want.

You pay this loan back in monthly installments, with interest, while continuing to make your normal payments on your original mortgage.

Rocket Mortgage® is now offering The Home Equity Loan, which is available for primary and secondary homes.

Home Equity Line Of Credit

Better known as a HELOC, a home equity line of credit is more like a credit card, only the credit limit is tied to the equity in your home.

If you have $40,000 of equity, you might qualify for a HELOC with a maximum spending limit of $30,000. This means you can borrow up to $30,000, but no more.

As with a credit card, you only pay back what you borrow. So if you only borrow $20,000 on a kitchen renovation, that's all you have to pay back, not the full $30,000.

Rocket Mortgage doesn’t offer HELOCs at this time.

The Bottom Line

Understanding how equity works is an essential step in preparing to buy a new home or refinance your current one. By leveraging the equity you build in your home, you’ll be able to consolidate debt, pay for renovations or make updates that increase your home’s property value in the long run.

However, it’s important that you explore your options and choose the right type of home equity financing for your needs. Before deciding on any of these home equity choices, be sure to speak with a mortgage professional who can help you understand the pros and cons of each.

If you’re ready to apply for a mortgage so you can buy a new home or want to refinance your current loan, you can get started online or reach out to one of our Home Loan Experts at (833) 230-4553.

1 Homeowner is still responsible for taxes, insurance and maintenance.

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