What to know about tapping into your home equity as interest rates drop
FILE-In this aerial view, single family homes are shown in a residential neighborhood in Miramar, Florida. (Photo by Joe Raedle/Getty Images)
The latest interest rate cut by the Federal Reserve may benefit homeowners when it comes to exploring options for their home equity.
Realtor.com noted that there are three ways to tap into your home equity: Cash-out refinancing, a home equity loan, and a home equity line of credit, or HELOC.
Although the Federal Reserve does not set mortgage rates, Fed rates and mortgage rates can move in the same direction, per Realtor.com.
Here’s what you need to know.
What is a home equity loan?
A home equity loan is a type of second mortgage that allows borrowers to pull cash out of their equity, while using the home as collateral. The loan comes as a lump sum, typically with a fixed rate.
What is a home equity line of credit?
A home equity line of credit, or HELOC, allows homeowners to borrow money against a portion of their home equity. This line of credit has a variable rate, and homeowners can use it when they need to or have it available for a later time.
According to Realtor.com, the average HELOC interest rate is 9.25%—and should decline more after the Federal Reserve’s expected interest rate cut. However, this type of loan requires homeowners to pay it back with interest.
What is cash-out refinancing?
Realtor.com explains in a release that in a cash-out refinance, homeowners get a new loan that is larger than what they owe. While the homeowner may keep the difference, they end up losing their old mortgage rate in the process. Approximately 86% of outstanding mortgages have an interest rate of 6% or lower, and most homeowners don’t want to give up their low-interest loans for new ones at much higher rates.
Separately, the least expensive way for you to take equity out of your home differs depending on the lender, but there are other factors lenders consider, including the homeowners’ credit score, loan-to-value ratio, and debt-to-income ratio.
If a homeowner has $300,000 or more in home equity, that does not mean they can tap into the full amount. Realtor.com noted that lenders typically allow homeowners to borrow between 75% and 85% of their home’s assessed value because it is considered less risky for the lender.
What’s the risk of tapping into home equity?
Borrowing against your home equity does come with risks.
One housing expert tells Realtor.com that one downside is if the value of the home drops, the homeowner may wind up owing more than what the house is worth, which could expose the homeowner to financial risks.
Another expert explains to Realtor.com that borrowing against your home has two factors. First, a lien can be placed on the homeowners’ house, meaning that they will not be able to sell their home until the debt is paid off or is settled at closing. Second, if the value of the home declines at a significant rate, the total amount of debt for your home will be more than the value of the home itself.