How much equity can you tap?
Home equity loans are back. The opportunity to get a cash-out refinance, home equity loan or home equity line of credit is once again alive and well.
But how much equity can — or should — you extract from your home?
Home equity options aren’t as aggressive or generous as those of yesteryear. But they’re not pocket change either, especially for longtime homeowners who have experienced rapid value appreciation in the past two years.
Years ago, homeowners could borrow up to 100 percent of their equity, says Jay Voorhees, broker and owner of JVM Lending, a mortgage company in Walnut Creek, California. Today, most lenders put significantly lower limits — like 80 percent to 90 percent — on home equity borrowing.
Voorhees says borrowers should “go to the limit” with a home equity line of credit, or HELOC, because they don’t have to tap the full amount of the credit line that’s available.
How much can they borrow?
Pat and Morgan bought a house in September 2009 for $172,000. They made a 20 percent down payment and refinanced three years later. In July 2014, they apply for a home equity line of credit.
Here’s how the bank calculates how much they can borrow:
■Home’s appraised value: $190,000
■Eighty percent of appraised value: $152,000 ($190,000 x 0.8)
■Amount Pat and Morgan owe on mortgage: $128,633
■Eighty percent of home’s value minus amount owed: $23,367
■The bank will give them a credit line of $23,367 or less.
That might be smart from a financial perspective, but for some people, the temptation of an open credit line can be a problem, says Alan Moore, a CFP professional for Serenity Financial Consulting in Milwaukee.
“Too often these loans have made our houses a bank account and made the equity very accessible, which is not always a good thing. You have to carefully consider: What are your long-term goals? What is the money for?” Moore says. “There is no reason to tap home equity unless you absolutely have to.”
Know how much you need
A conservative approach is also recommended for a cash-out refinance or home equity loan, either of which involves a fixed amount, rather than an open credit line.
Consumers who want to tap equity for home improvement projects — the most common use of this type of loan — usually settle on a specific amount, plus some wiggle room for cost overruns, says Kelly Kockos, home equity product manager for Wells Fargo in San Francisco.
“People have a budget in mind and they will manage to that budget versus saying, ‘Give me as much money as possible,’” she says. “It varies by the consumer and their personal situation, but they won’t necessarily push the outer boundaries of it.”
Interest rate hikes a risk
Cash-out refis, home equity loans and HELOCs aren’t risk-free.
Borrowers should try to pay off a HELOC, in particular, within a reasonable time, though they may elect to keep the line open for future use.
One reason to be conservative with a HELOC is that the interest rate can rise if market rates, such as the bank prime lending rate, move up. Rates are low today, but haven’t always been and might not always be.
“We encourage borrowers to pay it off if they can, and we warn them about the adjustable rate,” Voorhees says. “The prime rate was in the 8 percent range for much of the 1990s and the 10 percent range in the 1980s. Right now, it’s only 3.25 percent. If it goes up 5 percent, back to historic norms, they’re going to feel the pain on that equity line.”
Try Bankrate’s calculator to help decide whether to get a home equity loan or a HELOC.
Home values can crash
Another reason to be careful with home equity loans is that the value of your home can fluctuate, up or down, over time. If the value drops and you’ve extracted cash, you could end up owing more than your home is worth, says Justin Lopatin, vice president of residential banking for PERL Mortgage in Chicago.
“What if you take out all this money to do a home improvement project or make an investment and five years later, property values drop 10 percent? Now you have a higher balance and no equity,” Lopatin says. “That could be bad.”
Bad things can happen
Yet another risk is loss of your income to repay the loan, says Andy Tilp, president of Trillium Valley Financial Planning, a fee-only financial planning firm in Sherwood, Ore.
“Too many people used their equity as a piggy bank in the mid-2000s, only to discover the bank expects to be paid back. If the borrower is incapable of paying back the funds, they put their home in jeopardy,” Tilp says. “Anyone getting a loan against their home equity needs to have a plan in place to know they can repay it, even in the event of a job loss, poor investment returns and a drop in real estate prices.”
The bottom line is that home equity extraction can give you cash for whatever you need or want, but no matter how much you can borrow, any amount is too much if you can’t repay it.