If you’re like most Americans, the biggest contributing factor to your net worth is something you see every day: your house. The difference between the net worth of American homeowners vs. those who rent can be staggering for this very reason. In 2019, American homeowners had a median net worth of $255,000; for renters, it was just $6,300.
As you can see, a house is clearly a massive boost to your net worth. While retirement experts say that just 20 to 30 percent of your net worth should be real estate—including your personal dwelling—that’s often a lofty goal that many people in America don’t meet.
But is it worth it to have so much value in an asset such as a house? After all, your home contributing so much to your net worth on paper doesn’t necessarily mean anything in terms of doing the things you want your finances to help you do, like pay for your kids’ college, go on family vacations, or upgrade your car. You can’t buy your child the newest video game system with your house. Or can you?
As it turns out, there are several ways you can turn your home equity into real, hard cash in your pocket. In this article, we’ll talk about some key ways your home equity and mortgage can be a source of financial liquidity.
What Is Home Equity?
Your home equity—the amount of value in your home that contributes to your net worth—isn’t simply just the price of your home. Your home equity can be expressed with a simple math equation: the total value of your home, minus any liens (a.k.a. debts) someone else holds, equals your home equity.
For most homeowners, there will only be one primary lien on their home, and it’s their mortgage. When you purchase a home, the vast majority of the equity will go to the party that technically paid the most for the property, that is, the bank, credit union, or other institution that lent you the money. As you pay this off, you build home equity every month, mortgage payment by mortgage payment.
This is one of the reasons homeowners have such a higher net worth than renters. Both make payments every month (mortgage payments vs. monthly rent), but for homeowners, every payment contributes to the home’s equity, and therefore the owner’s net worth. For renters, it can feel a little bit like lighting the money on fire since there’s no permanent benefit from making those payments.
But while building home equity mortgage payment by mortgage payment is all well and good, how do you use it?
How to Access Your Home Equity
There are three primary methods you can use to turn your home equity into liquidity: a home equity loan, a HELOC, or a cash-out refinance. Let’s look at all three and how they differ.
1. Home Equity Loans
Home equity loans are exactly what they sound like—a loan borrowed against your home equity. This is a singular lump-sum loan that you then pay back as you would any other loan from your lending institution. Generally speaking, home equity loans have a maximum cap that is determined by comparing the value of your home against any debts you owe on it (i.e., your mortgage), which is otherwise referred to as a combined loan-to-value (CLTV) ratio. The more you pay off, the better your CLTV ratio and the more you can borrow.
2. Home Equity Line of Credit
A HELOC, or home equity line of credit, is similar in that it is cash borrowed against the value of your home. However, instead of being a one-time lump sum, it is (as it says in the name) a line of credit that you can borrow from as needed, up to a cap. Think of it like having a special credit card you can draw from. The maximum value is similarly determined by your CLTV ratio, but you can draw as much—or as little—of that amount as you need to. A HELOC is a great option when you’re not entirely sure how much money you might need to complete a project, such as when renovating your home.
A HELOC typically has two phases: the draw phase and the repayment phase. In the draw phase, you can borrow as much money as you want up to the cap, and you only accumulate interest on the amount you borrow. In the repayment phase, you can no longer draw funds. Instead, you simply pay back what you’ve borrowed plus interest, as you would any other loan.
3. Cash-Out Refinance
A cash-out refinance is different from the two above. Rather than being a separate loan you borrow against your home equity, a cash-out refinance can be thought of as an extension of your mortgage. In a cash-out refinance, as with any other mortgage refinance, you take out a new mortgage with different terms and use it to pay off the first mortgage. However, while with most mortgage refinancing, your new mortgage has a value equal to your first one—you’re just adjusting things like interest rates—with a cash-out refi, you take out a loan in excess of your current mortgage, getting the difference in cash.
This will mean that your mortgage takes longer to pay off, but it can be easier when compared to the other options since you only have one major loan to pay back instead of multiple.
Knowing how to tap into your home equity with a mortgage refinance, HELOC, or home equity loan can be a challenge. But you don’t have to navigate that challenge alone. Contact a trusted lending institution, such as Solarity Credit Union, to learn more. They have experts who can advise you on your next steps to turn your home equity and mortgage payments into liquidity and cash and take full advantage of your net worth.