The Ins and Outs of Tapping Into Your Home Equity

by JRO on November 15, 2013

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During the housing crisis in 2008, it was often said that people were “using their house as an ATM” to fund extravagant lifestyles.

What does it mean to use a house as an ATM? Below, I outline the basics of mortgage refinancing and the process of turning home equity into cash. Although this can lead to disaster, it can also be a great way to fund various life projects.

The Basics

First, let’s start with a basic primer on debt in the housing market and how it interacts with your home’s value. When someone wants to buy a house, they have two basic options: pay cash or finance the purchase. Paying cash, as you can imagine, involves paying the entire amount for the house up-front. Financing a house, on the other hand, involves taking out a mortgage. Mortgages have a variety of flavors, but the major differences are the length of the loan and the interest rate charged to the borrower. Often you’ll hear terms like “30-year fixed” or “one-year ARM,” all of which relate to rate and term.

The bank, or mortgage lender, will take your total loan amount, interest rate, and term to calculate your monthly payments. In the initial years of a mortgage, your monthly payments are used almost entirely to pay interest on your loan. The amount of money that was actually lent to you, called your principle amount, is usually untouched in the initial period of a home loan. It’s important to note here that the amount you pay in mortgage interest is deductible from your annual taxable income.

Equity

Once you’ve purchased your home, it now has a corresponding value. For example, let’s say you just financed a house for $250,000. You paid a $20,000 down payment and thus financed $230,000 of the purchase. That $20,000 difference between the loan amount and the value of the house is called home equity. Keep in mind that home values aren’t like stocks and bonds; the market doesn’t move that quickly. Often the value of a home is determined by something called “comparable value” or “comps” for short. To determine a home’s comp value, a house is compared to other recently sold houses in the surrounding area, taking into account square footage and other amenities.

How to “Tap” Into your Home Equity

You only have equity in your home if it’s worth more than your loan principle. If you have it, there are several ways to cash-in on the equity of your house. For one, you can sell the house — including closing costs and realtor fees — for more than what you owe on your mortgage principle. If you aren’t in a position to sell your house, this may not be a good option for you.

You can also refinance or get a home equity loan or line of credit. To quote the Federal Reserve Board, “when you refinance, you pay off your existing mortgage and create a new one.” Perhaps interest rates have fallen, maybe your FICO score has improved so you’re eligible for a better rate, or perhaps you want to change your 30-year term into a 15-year deal. These are all good reasons to head back to the bank for refinancing. Bear in mind, however, that there are often significant costs to refinancing, and these should be included in your calculations. A home equity loan (often called a second mortgage) or line of credit is a loan that uses your equity on your home as collateral.

It’s always important to remember that each option carries its own risks and rewards. Be diligent before making any long-term financing decisions.

Byline

Bryan Mortensen writes on Business Disputes, Commercial Law, Property Law, Mortgages, Banking Law and other related matters.

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