Which Home Equity Option is Best for You?

One of the top reasons why you may want to own a home instead of renting an apartment is equity. Even if you don't own your home outright, as you make payments on your mortgage, you own more and more of your home. The portion of the house's value that you own (versus what's owned by the mortgage lender) is your equity.

One advantage of having equity in your home is that, should you need an infusion of cash, you can often tap into that built up equity. There are multiple ways to access your home's equity, each with their own features, benefits, and drawbacks. If you're thinking of borrowing against your home's equity, consider the pros and cons of these four home equity options.

Home equity loan

A home equity loan is sometimes called a second mortgage because it functions similarly to a traditional mortgage. You get a loan that's secured by your property; in this case the loan is secured not by the entire home, but by your equity in the home. 

Just like a regular mortgage, the home equity loan will have a set repayment period (typically 5 to 30 years), a single monthly payment, and a fixed interest rate.

Risks of a home equity loan

• Foreclosure: Just like with a primary mortgage, if you stop making payments on your home equity loan you could lose your home. Even if you stay current on your mortgage, defaulting on a home equity loan could cost you your home.
• Costly interest payments: Depending on your credit and the size of the loan, the interest rate may be reasonable, but decades of interest charges can add up substantially.
• Lump payment: With home equity loan you're accessing your entire equity all at once, with a single lump sum payment. That equity won't be available to you again in the future until you repay the loan or build more equity.

Best for...

Home equity loans are best used by consumers who have a large, one-time expenses they need to cover. This could be a sudden medical expense, a major renovation to your home, or consolidating multiple expensive debts into something more manageable.

Home equity line of credit (HELOC)

Want to be able to access the equity in your home, but don't want all that money at once? You may want to consider using a home equity line of credit (HELOC).

With a HELOC you can create a line of credit worth some percentage of your home's current equity (usually 85% to 95%). The HELOC includes a draw period and a repayment period.

The draw period typically lasts five to 10 years, during which you can borrow against this line of credit, while only making payments on the interest that accrues. The repayment period follows the draw period and is usually 15 to 20 years. As the name suggests, this is when you start repaying the balance of the amount you borrowed during the draw period, plus interest.

Risks of a home line of credit 

• Foreclosure: As with most home equity options, any time you use your home as collateral to secure a loan, you risk losing your home if you default on your payments.
• Variable interest rates: Most HELOCs come with a variable interest rate, which means it can be difficult to pin down exactly how much you'll be paying every month. And if rates increase, your budget may be strained more than you thought possible.
• Risk of overspending: A HELOC is a little like a credit card with a massive credit limit. During the draw period it may be easy and tempting to dip into more of your equity than you intended, leaving you with a large debt to handle during the repayment period.

Best for...

HELOCs are ideal for home improvement projects. They give you flexibility to draw funds as needed and, best of all, if you use a HELOC to improve the value of your house (by drastically remodeling or adding an addition), the interest on your HELOC may be tax deductible.

Cash-out refinancing

It's pretty common to refinance your home mortgage fora new loan with better terms. Usually when you refinance a mortgage you're paying off the remaining balance of the old mortgage with the new mortgage. 

In a cash-out refinance, you get a new for up to the current value of the home. This includes any built up equity. The old mortgage gets paid off and the extra funds (the equity) goes straight to you. Now you've got a new mortgage with a much higher remaining balance.

Risks of a cash-out refinance

• Reset the mortgage clock: If you've got equity, that means you've probably made a lot of progress repaying your mortgage. Cashing out that equity functionally sends you back the start with a new 30 year mortgage. Even if the rate is favorable, you're long-term interest costs will be sizable.
• Closing costs: Creating an entirely new mortgage is typically more expensive than opening a home equity loan or a HELOC, so the upfront fees may be more substantial.

Best for...

Cash-out refinancing is best for homeowners with great credit who qualify for the best mortgage terms and can handle the new, larger loan balance.

Home equity sharing agreement (HSA)

Home equity sharing agreements are a newer option on the scene. Unlike a home equity loan, where a lender is letting you borrow against your home's equity, in a home equity sharing agreement an investor gives you cash in exchange for a percentage of the home's future value.

In other words, the third party is investing with the expectation that the value in your home will grow over the time. You receive the money upfront and make no monthly payments. Instead, you'll have to make a single (often massive) payment at the end of the term (typically 10 to 30 years).

Because the product isn't a loan, the application requirements are lower as compared to home equity loans or HELOCs.

Risks of a home equity sharing agreement

• You may need to sell your home: That massive payment at the end of your 10 to 30 year term may simply be too big to repay without selling your home.
• Foreclosure: Even though the home equity sharing agreement isn't a loan, it does create a lien on your property, which means that failure to pay can result in you losing the house.
• Access to less equity: If your goal is to cash out the equity built up in your home, an HSA won't get you nearly as much as the other options. The actual percentage is dependent on the total value of your home, the amount you still owe on your mortgage, and other qualifying factors.

Best for...

Home equity sharing agreements are most appropriate for homeowners who don't qualify for other home equity options. They can be very costly, and you may have to sale the house in order to repay the debt, but if you're in a tight situation and you need a lot of cash immediately they may be your only option.

If you're a homeowner and you're struggling financially, MMI offers free financial counseling 24/7, online and over the phone. Let our experts review your situation and provide advice and guidance tailored to your needs and goals.