How to Safely Tap Home Equity in a Financial Emergency
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Your home equity shouldn't be the first line of defense when the roof falls in. But it can be a useful resource to seal a temporary financial gap, and most homeowners have a lot more wealth tied up in their property than they did a couple of years ago.
In the third quarter of 2021, the average homeowner gained $56,700 in equity year over year, according to the latest equity report from CoreLogic, a property data provider. In 2020, the average annual gain was $26,300, which then was the largest since the third quarter of 2013.
That's a sizable chunk of change.
Offers in your mailbox may tout ways to turn rising home value into cash. But borrowing against home equity — the market value of the home minus the amount owed on the property — shouldn't be taken lightly.
"It's not free money," says AnnaMarie Mock, a certified financial planner with Highland Financial Advisors in Wayne, New Jersey.
Safely tapping into home equity requires understanding the costs and risks, thoughtfully planning and shopping around to find the best deal. Here's what to do.
Know your options
Typically a bank will lend up to 80% of a home's value, or sometimes more, Jon Giles, head of consumer direct lending at TD Bank, said in an email. On a $300,000 home with an 80% lending limit, the amount of the mortgage and any home equity borrowing could total up to $240,000. So if you owed $150,000 on your mortgage, you might be able to borrow as much as $90,000 of your equity.
Here are three ways to access home equity:
A home equity loan provides a lump sum that's repaid at a fixed interest rate over a certain number of years. It provides consistency and can work well for a big-ticket item, such as a home improvement project.
A home equity line of credit, or HELOC, is like a credit card with an adjustable interest rate. During the draw period, typically 10 years, you can take out cash as you need it. Your monthly minimum payments are usually interest-only during the draw period, but you can pay more. During the subsequent repayment period, you repay principal plus interest on anything you borrowed. A HELOC offers flexibility, providing access to cash when you need it with no interest charged if nothing is drawn.
A cash-out refinance replaces your current home loan with a new mortgage that exceeds the amount owed on the property. A portion of the difference is paid out in cash when the loan closes. It can be a good option if you can get a lower interest rate than your current mortgage, but you'll pay 2% to 5% of the loan amount in closing costs. One rule of thumb says it may be worth refinancing if you can cut the mortgage rate by three-quarters of a percentage point.
A reverse mortgage is another option for accessing home equity, but it's a different animal and available only to homeowners 62 and older.
Understand the risk
Your home serves as collateral when you borrow against home equity, just as it does for your mortgage. That means you risk losing the home if you can't repay.
A worst-case scenario: You borrow against all the home equity you can. The housing market craters — think of the Great Recession in 2008 — and home prices plummet. A life change necessitates a move, and you have to sell the house when you owe more than it's worth. Or you get laid off and have already leveraged everything to the hilt.
"A borrower needs to understand their own situation and their overall financial health to make sure they are not risking their home," Giles says.
Borrow for the right reasons
"You have to get really specific about the highest and best use of that asset," says Jamie Lima, a CFP and founder and president of Woodson Wealth Management in Ramona, California. "Write down the goals: This is what we're using this money for. This is the exact money we're going to spend and this is our budget. Once you see it on paper, it's an opportunity to say, 'Does this make any sense, and what is the benefit to us?’"
A HELOC can be a strategic way to supplement an emergency fund when interest rates are low, Mock says. For instance, instead of keeping six months of expenses in a savings account, you could keep two or three months of income on hand and put the rest in an investment account, where it will have the opportunity to earn more than it would in a savings account. The HELOC would serve as a backup if something big happened and you depleted your cash emergency savings.
Some financial experts caution against borrowing against home equity for things that don't hold value, such as cars, or unsecured debt, such as medical bills. For medical bills, consider other alternatives first, such as negotiating the bill with medical providers and working out a payment plan.
Establish credit before you're desperate
If you think you'll need to tap into home equity, don't wait until the 11th hour to apply for credit. The application and approval process takes anywhere from two weeks to two months, Giles says.
“If you think you'll need to tap into home equity, don't wait until the 11th hour to apply for credit.”
And it may be too late if you've already lost a job and have no income — you probably won't qualify.
"You have to establish the line of credit prior to needing it," says Jim Crider, a CFP and CEO of Intentional Living FP in New Braunfels, Texas.
He used a HELOC to help support his family after he left a full-time job to start his financial planning business. Crider got the HELOC before he quit as part of a carefully plotted strategy. In the first four months of building the business, he used money from savings to support the family. Then, he drew money from the HELOC to supplement income as needed. He also had a personal line of credit established just in case.
This allowed him to avoid pulling money out of investment accounts and losing out on potential gains in the stock market. He says the strategy kept the family of five comfortably afloat, and the business soon provided more income than he made at his previous job.
Set and stick to a repayment plan
Set a timeframe for repayment. Make sure you can afford the monthly payment and understand how this will affect savings for other goals, Mock says.
Without a good repayment strategy — one that meets your goals, not just the lender's requirements — home equity loans and HELOCs can look more affordable than they are. For instance, the term for repaying a home equity loan can be as long as 30 years. The monthly payments for a large purchase can seem affordable when stretched over that long period. "What is not seen is all of the interest expense that will be paid over the 30 years," says Anthony Watson, a CFP and founder of Thrive Retirement Specialists in Dearborn, Michigan.
HELOCs, meanwhile, often require interest-only payments during the draw period, so the minimum payments are low. Paying only the minimum does not reduce the debt, which will have to be repaid plus interest after the draw period ends.
"It's so easy to access that it can be a slippery slope," Watson says. "It really does have to be used with care and for a proper purpose."
A HELOC is probably not a good idea if you or your partner tends to max out credit cards or you think one of you might use it irresponsibly, Blake Jones, a CFP and founder of Pomegranate Financial in Springville, Utah, said in an email.
Shop around and read the fine print
Rates and fees will vary, so compare offerings from multiple banks and credit unions to get the best deal, Crider says.
Ask about how the loan or line of credit works, the interest rate, how or whether it will change and all the fees that apply.
For instance, many banks or credit unions don't charge an annual fee for having the HELOC open, but some do, says Jones, a former banker. You might also reconsider if you plan to move in a few years. Often there's an early closure fee if the HELOC is closed within a certain period of opening it, he says. The HELOC or home equity loan will have to be paid off when the sale closes.
Your home equity can be part of a financial safety net, but using it requires preparation. A financial planner can help you see how home equity borrowing fits into the big picture. Ask a loan officer to walk you through the options, costs and repayment requirements.