It's not rare to hear about others who cash out on the equity in their home. Why would anyone not want to take advantage of this free money?
But there is a dark side with tapping into the equity of your home.
This easy money might seem “free”, but you are ultimately borrowing from future cash when you sell your house.
How to Withdraw Equity from Your Home
If you have over 20% equity in your home, the chances are good that you have the option in cashing out on that extra equity. Some lenders allow you to pull out up to 85% of the loan. Here are the two most common ways to do this:
- Cash out refinance
- Home equity loan (2nd mortgage)
- Home equity line of credit (HELOC)
Let's say your house appraises for $150,000, and you have a mortgage for $80,000. You could refinance your current mortgage into a larger loan of $120,000 (which leaves $30,000/20% equity). You then would pocket the $40,000 cash. With this option, you would pay the closing costs of the new lown (most likely).
The other options are taking out a home equity loan (2nd mortgage) or line of credit (HELOC). You can take a lump sum or open a line of credit account that you can borrow against. If you take out a home equity loan, you will need to cover the closing costs on the loan, but your interest rate is set in stone. Home equity line of credit accounts are usually easier to set up and have lower upfront fees, but some come with other charges and gotcha's if you don't pay off the balance over a certain period (in addition to having a variable rate). With both of these options, you aren't directly removing equity; you are just borrowing against your home.
HELOC's work like an account where you can pull out cash.
How do most people spend this cash?
If people are not making sound financial decisions before taking out equity in their home, chances are they will make the same types of choices when accessing the “easy” money from their home equity.
I'm sure there are exceptions to this rule, but I've heard of several scenarios with people I know who paid off a bunch of debt, only to rack up more debt and end up in a weaker financial position after cashing out their home equity.
It's far too easy to feel like you can go on a spending spree when you receive a large lump sum of cash. You start to think about all the things you want that you don't have, and these thoughts spiral into building up excitement for these purchases. Maybe it's a new car you don't need or new home furnishings.
But going into debt on things that depreciate is not sustainable.
The ultimate goal is to get to a spot where your money is making you more money. If you can spend less than you make and save money, you are producing little workers for yourself that can generate income. When you take on consumer debt, you are doing the exact opposite. You end up paying the amount you could earn to credit companies, and make it harder to reach financial independence.
Is it a good idea to tap into the equity from your home?
There are a few reasons you want to think long and hard about whether this is a smart financial move:
- What are you going to spend these funds on?
- Are you adding additional risk to your financial picture, if things take a turn for the worst?
- How long do you plan on living in this home? Could these plans change?
- If you are doing a cash-out refinance, will you get a better interest rate than what you have now?
- Take a close look at the fees associated with each option. With a cash-out refinance and home equity loan, you will most likely have to cover the closing costs for the new loan, which can be hefty.
- Do you have a strong credit score?
There are multiple levels of risk in cashing out on your home equity. Below is what I consider the most important aspects of whether or not you should go with this approach.
How are you spending the funds?
Paying off debt using the cash from your home equity can be a smart move in some situations, like when you are paying off high-interest debt. These debts could include credit cards, auto loans, student loans, or personal loans. You could save on interest and make your finances easier to manage.
But if you pay off these debts, only to replace them with other bad debts, this is a bad financial move.
Instead of making progress on your net-worth, you are reducing the equity in your house to be in the same financial spot (except with less home equity). Instead of making your financial position stronger, you are going in the opposite direction because you are using future funds with what you will (in theory) get when you sell your home.
You could put yourself in a huge financial advantage in the future if you use these funds wisely. Unfortunately, I don't think most people realize how serious this financial decision is.
If you can get to the bottom of why you went into debt, and prevent that from happening again, it could be a smart way to play financial catchup. You could end up saving a considerable amount of money on interest charges by rolling those funds into your mortgage loan, or use those funds to increase the value of your home.
But each option has different pros/cons. With a HELOC or home equity loan, you are repaying that amount and aren't directly giving up any equity on your house when you sell (unless you don't pay them off before you sell). But with the cash out option, you get 100% cash and don't have to pay it back (but they usually have more fees to pay and are riskier).
Cashing out on your home equity could work out great if home prices rise in the future. But what if the reverse happens? You could be faced with having to sell your house for less than the mortgage, which could prevent you from being able to sell the house when you want to.
Just look at what happened during the housing crisis of 2008 where people were underwater with their mortgage. I haven't experienced this myself, but the feeling has to be awful. You are paying for a house that isn't able to cover the mortgage until/if the housing market recovers.
You could limit the risk by leaving yourself a healthy equity cushion in your new mortgage loan and not taking out the maximum amount you can withdraw. Or you could take out a home equity loan/HELOC and pay it off (which would leave your equity untouched, but you would pay fees).
Especially if you have a solid plan in how you will use those funds, and if it will put you in a stronger financial position, this could make one of these options attractive.
If you take out a HELOC, it isn't like a credit card balance. If you don't make the necessary minimum payments, they could end up taking your house. In a way, this makes HELOC's much riskier than credit card debt. But this is probably a better option than doing a cash-out refinance.
With all the options in withdrawing equity on your home, you are going to have to cover some fees. These fees can take a considerable bite out of how much you have access to.
When you refinance your mortgage or take out a home equity loan, you will most likely have to cover closing costs. This fee ranges from 2%-5% of the total amount of the loan. 4% of $120k is almost $5,000.
With a HELOC, and carrying a balance, you run the risk of interest rates increasing. You also should expect these interest rates to be higher than your original mortgage loan, but it still will most likely be much less than most credit card interest rates. Since the interest rate of a HELOC can change, it might be hard to figure out how much to budget to pay every month.
If you can get a lower interest rate by refinancing your current mortgage (cash-out refinance), this could end up saving you money.
But you should also consider how much mortgage interest you have already paid because you are resetting that process. As I figured out when I took a look at whether we were going to pay off our mortgage early, you pay the most on interest with fixed-rate loans towards the beginning of the loan. The farther down the road you get with your mortgage loan, the more principle you will pay down every month.
It might make sense to refinance your mortgage if you plan on working for the next few decades and staying in your house. But are you at a point where you are ready to commit to doing that?
Even if the best rates you can get are lower than what you have, if you don't have a high credit score, you might not be able to land the best rates.
In our case, we have a fixed rate 30-year mortgage at 3.625%. So I don't think we will see anything lower than that for a while.
HELOC as an Emergency Fund
I've heard of some people opening a HELOC as a replacement or supplement for their emergency fund. The argument is that this is cheap credit that you can tap into in case of an emergency.
The main risks with this approach are the following:
- You'll pay some fees to have this account open.
- The interest rate will be variable.
- The bank could freeze or close your HELOC at any point.
- You are putting your home at risk.
The most significant risk with this approach is that if you do need to tap into these funds, you are taking on additional debt that you will need to pay off. Maybe the rates are low right now, but they could go up significantly in the future. And if we encounter another housing crisis, you might not be able to tap into these funds at all.
If we encounter another significant economic downturn, and banks start struggling again, they might decide to lock or close HELOC's to limit the amount of risk. The last thing you want is to encounter an emergency when the funds you depended on are no longer available.
In my opinion, the goal of an emergency fund is to make it less likely you will have to go into debt. The last thing you want to do when faced with an emergency is to worry about having debt. I've done this in the past, and it left me feeling behind and frustrated. Dealing with a crisis in itself is stressful enough. You don't want to add more stress if you can avoid it.
There is nothing as liquid or accessible as cash. Sure, this money may not keep up with inflation. But I know the money is secure and will be available when I need it.
Think about What is the Best Financial Move
We all have different scenarios that are unique to our situation. Maybe debt consolidation makes cashing out your home equity a smart move.
If I was to rank each option from what I consider the best and lowest risk, this is how I would rank them:
- Home equity loan
- Cash out refinance
With options #1 and #2, you are promising to pay off that debt (with your house working as collateral). You don't give up any tangible equity unless you don't pay off the balance by the time you sell. Option #3 you are 100% giving up that equity. But you also don't have to worry about a fluctuating interest rate vs a HELOC (assuming you go with a fixed rate loan).
However, I would say in most cases, you are probably best not to go with any of these options. That way, you can focus on solving the core problem and not adding additional risk to your financial life. Do you really want to spend future cash that you could have when you sell your house? Or do you want to risk having to go into foreclosure because you lost your job and you need to sell your home, but can't sell it for more than your mortgage?
I'm not 100% sure how long we are going to stay in our house, or how the future is going to look. The last thing I want to do is put my family at risk because I took out equity from our home or borrowed against the home equity. Who knows, we could find ourselves in another housing market crash or major economic recession. In that case, I don't want to put our home on the line.