What is home equity financing?

Owning a home is one of the best ways to build wealth. Over time, your home will appreciate in value as your mortgage balance is paid down. This builds equity in your home that you can use for retirement, to start a business, consolidate debt, and more. Home equity financing is a way to borrow money from your home equity without selling your house. Here's how a home equity loan works, the pros and cons of this strategy, and the different types of home equity financing to consider.

What is home equity financing?

Home equity financing is when you borrow money using a loan secured by your home. There are many different ways to borrow against your home equity without selling your home.

The amount of money you can take out of your home depends on its value, your first mortgage balance, and the lender's maximum loan-to-value (LTV) ratio. For example, say your home is worth $400,000, and you have a $250,000 mortgage balance. If the lender allows up to a 90% LTV, then you can withdraw up to $110,000 from your home's equity.

Depending on what type of financing you choose, your monthly payment and interest rate may be variable or fixed, and you may receive the loan proceeds all at once in a lump sum or have flexible access through a line of credit. In some cases, you won't have monthly payments at all. With so many variables, it is important to understand the pros and cons of each type of home equity financing to choose the best loan option to meet your needs.

Pros and cons of home equity financing

Pros

• Lower interest rate. Loans secured by property tend to have lower interest rates than unsecured loans or loans secured by other assets.
• Access to larger borrowing amounts. Home equity loans tend to have larger loan amounts than other types of financing.
• Tax advantages. Depending on what the money is used for, you may be able to write off the interest charged by home equity financing.
• Longer repayment period. Home equity loans tend to have longer repayment periods than personal loans.

Cons

• Puts your home at risk. With your home as collateral, if you miss payments or default on the loan, you could lose your home.
• Longer decision timeframe. Lenders typically take 15 to 45 days to underwrite and approve home equity financing, compared with some loan options that can be approved much faster.
• High closing costs. Some home equity financing options have high closing costs that reduce the savings compared to other borrowing methods.
• Potential negative equity. If your home loses value, your mortgage balance may exceed your home's value.

Types of home equity financing

When used effectively, home equity can be a valuable tool for achieving financial goals. If you're interested in withdrawing cash from your home, here are a few of the most popular home equity financing options you should consider. Be sure to compare how they work, interest rates, monthly payment requirements, and other considerations to find the loan that meets your needs.

Home equity loan

A home equity loan provides a lump sum of cash with a fixed interest rate and a consistent monthly payment. As a secondary loan, your primary mortgage is not affected, so you won't lose your current interest rate. Loan terms vary, but borrowers can usually choose between loan repayment periods of 5 to 20 years.

• Fixed interest rate and predictable monthly payment
• Ideal for consolidating credit card debt, home improvement projects, and other larger borrowing needs.

Home equity lines of credit (HELOCs)

Home equity lines of credit provide a maximum credit limit that you can borrow against repeatedly. In most cases, your "draw period" is 10 years, then any outstanding balance converts into a 20-year term loan.

• Borrow only what you need, when you need it
• Interest-only payments during the draw period
• Variable rates can increase monthly payments over time

Many HELOCs allow borrowers to convert some or all of their balance into a home equity loan. This locks in the current interest rate and turns the line of credit into an amortizing term loan with a fixed monthly payment.

Home equity investment (HEI)

A home equity investment is an innovative form of home equity financing. Unlike a traditional loan, the homeowner shares a portion of their home's appreciation instead of making monthly payments. You can settle the investment at any time over the next 30 years, or wait until you sell or refinance the home.

• No monthly payments
• Can be approved with a bad credit score
• No income or debt-to-income ratio requirements
• Repayment tied to change in home value at time of settlement

Cash-out refinance

A cash-out refinance replaces your current mortgage with a new one that has a higher balance. With a cash-out refinance, your new loan amount is the combination of your existing loan plus the cash you pull out of your home equity.

• Works best when interest rates are lower
• Potential to lower your monthly mortgage payments or increase them to pay off the mortgage faster
• Higher loan balance and closing costs

Reverse mortgage

Reverse mortgages are special types of home equity financing that are only available to qualifying seniors. There are three main types of reverse mortgage payouts: lump sum of cash, equity line of credit, and annuity payments.

• Higher closing costs than a conventional mortgage.
• Still responsible for all utilities, property taxes, insurance, and maintenance on the property
• Repaid when the home is sold, refinanced, or no longer serves as the primary residence
• Not assumable by heirs

The bottom line

So, what is home equity financing? These loans are a way to get additional cash out of your home. While some loans keep your existing home loan (and interest rate) in place, others require you to replace your mortgage with a new one. There are many different types of home equity loans with variable and fixed interest rates, and interest-only and amortizing monthly payments. Depending on which financing option you choose, you’ll receive the cash as a lump sum, through a line of credit, or in monthly annuity payments.