How to safely tap into your home’s equity in a financial emergency

The equity in your home shouldn’t be the first line of defense when the roof collapses. But it can be a useful resource for filling a temporary financial void, and most homeowners have far more wealth tied up in their property than they had a couple. years ago.

In the third quarter of 2021, the average homeowner earned $56,700 in equity year over year, according to the latest equity report from CoreLogic, a real estate data provider. In 2020, the average annual gain was $26,300, which was then the largest since the third quarter of 2013.

It is a considerable change.

The offers in your mailbox may tout ways to turn the growing home value into cash. But borrow against home equity – the market value of the house minus the amount owed on the property – should not be taken lightly.

“It’s not free money,” says AnnaMarie Mock, Certified Financial Planner at Highland Financial Advisors in Wayne, New Jersey.

To safely tap into the equity in your home, you need to understand the costs and risks, and plan and shop wisely 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 direct consumer lending at TD Bank, said in an email. On a $300,000 home with an 80% loan 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 could borrow up to $90,000 of your principal.

Here are three ways to access the equity in your home:

  • A home equity loan provides a lump sum that is repaid at a fixed interest rate over a number of years. It provides consistency and can work well for an expensive 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 drawdown period, usually 10 years, you can withdraw money as needed. Your monthly minimum payments are usually just interest during the draw period, but you can pay more. During the next repayment period, you repay the principal plus interest on everything you borrowed. A HELOC offers flexibility, giving you access to cash when you need it with no interest charged if nothing is drawn.
  • A cash 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 in cash at loan closing. This 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. A rule of thumb says it may be worth refinancing if you can lower 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 only available to homeowners 62 and older.

Understand the risk

Your home serves as collateral when you borrow against your home equity, just like your mortgage. That means you risk losing the house if you can’t pay it back.

A worst-case scenario: you’re borrowing against all the equity in your home that you can. The housing market craters – think of the Great Recession of 2008 – and house prices plummet. A life change requires a move, and you have to sell the house when you owe more than it’s worth. Or you are laid off and have already fully exploited everything.

“A borrower needs to understand their own situation and overall financial health to ensure they don’t risk their home,” says Giles.

Borrow for the right reasons

“You have to be very specific about the highest and best use of this asset,” says Jamie Lima, CFP and founder and president of Woodson Wealth Management in Ramona, California. “Write down the goals: that’s what we’re using this money for. That’s the exact money we’re going to spend and that’s our budget. Once you see it on paper, it’s an opportunity to say, “Does this make sense, and what’s the benefit to us?” »

A HELOC can be a strategic way to supplement an emergency fund when interest rates are low, Mock says. For example, instead of keeping six months of expenses in a savings account, you can keep two or three months of income and put the rest in an investment account, where it will have the opportunity to earn more than in an account. savings. Account. The HELOC would act as a backup if something big happened and you used up your emergency cash savings.

Some financial experts warn against borrowing against home equity for things that have no value, like cars, or unsecured debt, like medical bills. For medical bills, consider other alternatives first, such as negotiating the bill with medical providers and working out a payment plan.

Build credit before you get desperate

If you think you need to tap into the equity in your home, don’t wait until the 11th hour to apply for credit. The application and approval process takes two weeks to two months, says Giles.

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 before you need it,” says Jim Crider, CFP and CEO of Intentional Living FP in New Braunfels, Texas.

He used a HELOC to support his family after quitting a full-time job to start his financial planning business. Crider got the HELOC before stepping down as part of a carefully plotted strategy. During the first four months of starting the business, he used the money from his savings to support his family. Then he withdrew money from the HELOC to supplement his income as needed. He also had a personal line of credit set up just in case.

This allowed him to avoid withdrawing money from investment accounts and losing potential gains in the stock market. He says the strategy kept the family of five comfortably afloat and the business soon generated more income than he was earning in his previous job.

Establish and stick to a repayment plan

Set a repayment deadline. Make sure you can afford the monthly payment and understand how that 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 seem more affordable than they are. For example, the repayment period for a home equity loan can be up to 30 years. Monthly payments for a major purchase can seem affordable when stretched over this long period. “What you don’t see is all the interest costs that will be paid over the 30 years,” says Anthony Watson, CFP and founder of Thrive Retirement Specialists in Dearborn, Michigan.

HELOCs, on the other hand, often require interest-only payments during the drawdown period, so minimum payments are low. Paying only the minimum does not reduce the debt, which will have to be repaid plus interest after the drawdown period ends.

“It’s so easy to get to, it can be a slippery slope,” says Watson. “It really needs to be used with care and for the proper purpose.”

A HELOC probably isn’t a good idea if you or your partner tend to max out credit cards or think either of you might be using it irresponsibly, said Blake Jones, CFP and founder of Pomegranate Financial in Springville, Utah, in an email.

Shop and read the fine print

Rates and fees vary, so compare offers from multiple banks and credit unions to get the best deal, Crider says.

Find out how the loan or line of credit works, the interest rate, how or if it will change, and any fees that apply.

For example, many banks or credit unions don’t charge an annual fee for opening the HELOC, but some do, says Jones, a former banker. You might also reconsider if you plan to move in a few years. There are often early closing fees if the HELOC is closed within a certain time after opening, he says. the HELOC or home equity loan must be paid at the closing of the sale.

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 explain repayment options, costs and terms to you.

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Barbara Marquand writes for NerdWallet. Email: bmarquand@nerdwallet.com. Twitter: @barbaramarquand.

The article How to safely tap into your home’s equity in a financial emergency originally appeared on NerdWallet.