When Is It Smart to Take Equity Out of Your Home?

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Should you treat your home like a piggy bank?

You should only take equity or money out of your home if you:

  1. Expect to have significant financial needs such as medical costs or tuition that you don’t expect to be able to repay in a short amount of time. In this case, alternative financing from credit cards or payday loans would not be sufficient and would cost you much more than the fees involved in refinancing your home.
  2. Have a steady income that can pay for the mortgage and want to borrow from your equity in order to invest. Interest rates for secured loans such as mortgages or Home Equity Line of Credits (HELOCs) tend to be lower than personal loans, other unsecured lines of credits, or borrowing from your stock broker, so this can be an attractive option for those willing to handle to risk. 
  3. Have other loans or lines of credits such as credit card debt, car loans, or payday loans that have higher interest rates than your mortgage or HELOC. Using your equity to pay off these loans can save you a lot on interest. 

How can you borrow money from your home?

There are three common paths to choose from if you’ve decided to borrow money from your home:

  1. Refinancing and borrowing from your current mortgage,
  2. A HELOC,
  3. Getting a second mortgage,

Getting a second mortgage is often ill-advised because it often charges a higher interest rate than your original mortgage and doesn’t have the flexibility of a HELOC. We will focus on the first two options instead. If you believe a second mortgage may be the only option for you, talk to a mortgage broker and get advice on what would be the best option for you. 

Refinancing your current mortgage

If you refinance your mortgage, you can often change the terms of your mortgage to increase the amount remaining, withdrawing the money for other purposes. Whether or not you can do this depends on how much you have already paid off and the appraised value of your home. In Canada, you can often borrow up to 80% of the value of your property. If you have less than 80% of the value remaining on your mortgage, or your property price has gone up to the point where you no longer owe the same proportion of the property value, you may be able to add onto your mortgage and take money out. To estimate the current value of your home, you can check comparable listings around you or use an online estimator such as Wowa’s Instant Property Valuation Estimator

One of the benefits of refinancing is that it keeps things simple. You can often continue with your current lender and simply increase the regular payments you already make towards paying down your mortgage. In addition, unlike a HELOC, if you keep making regular payments your lender won’t bother you even if your property value drops so that your total borrowed amount exceeds the 80% threshold. However, you can’t easily make prepayments or pay down your extra debt faster the same way you can with a HELOC.  

Taking out a Home Equity Line of Credit (HELOC):

A home equity line of credit provides you with a line of credit with a pre-approved limit (like a credit card). Also like a credit card, you can draw from and pay back into it whenever you want. There is, however, no grace period where you won’t be charged interest until a certain date – the moment you withdraw from the HELOC, interest starts accruing. Compared to mortgages, HELOCs tend to have higher and variable interest rates. 

In Canada, you can only finance up to 65% of your home’s market value or purchase price with a home equity line of credit while US homeowners are eligible to finance up to 80% of the home’s loan-to-value ratio for the HELOC. These numbers include the amount remaining on your mortgage, so if you still owe 50% of your home value on your mortgage, you would only be eligible for a HELOC of up to 15% in Canada or 30% in the U.S. Other conditions, including income requirements, may also apply depending on the lender. 

HELOCs are usually the preferred borrowing option when you have certain expenditures spread over a couple of years (e.g. college tuition payments) or want to do interest-only payments for a period of time (such as in investing). Although HELOCs rates are higher, you have the flexibility of borrowing only the amount you need and pay interest only on that amount.

When is it okay to take equity out from your home (and which option should you choose)?

Borrowing money from your home can be a slippery slope. You need to be careful that you are able to afford your repayments and pay back the money that you owe, or else your lender could potentially take away your home. This is one of the reasons why mortgage interest rates are so much lower compared to those of other loans: lenders know that you will do everything you can to make payments on your home.

One piece of advice is to only borrow money when you truly need it and for something that tangible and one-time only. Borrowing from your home for regular expenses is dangerous since, unlike unsecured loans such as credit cards or payday loans, your lender has the right to your home and can take it away if you fail to repay. 

When to choose to refinance your mortgage

Since the interest rate charged on your mortgage tends to be much lower than that of other loans, it makes sense to refinance your mortgage to pay back other debt that you may have. Good reasons to refinance include: paying off student loans or credit card debt or long-term or large expenditures such as loans you may use to start your own business or investing. Remember that taking out a larger mortgage will add to your mortgage payments – it is critical that you can fit the increased payments into your budget. 

When to choose to take out a HELOC

A HELOC is excellent for small loans, especially if you want flexibility while paying back the loan. For example, if you’re going on a special trip/vacation, a HELOC is perfect as you can pay it back over the course of the year without the high interest rates of credit card debt. 

One of the benefits of a HELOC is that you don’t have to use it if you don’t need to, and there are no fees with keeping it open. This gives you a financial buffer to draw from if you have any unexpected expenses or sudden unemployment. The lower interest rate and lack of fees also make it much more affordable than going into credit card debt or payday loans. In fact, some people choose to put all their money into investments or paying down other debt and use their HELOC as their main expenses account and emergency fund. 

People go wrong with HELOC when they go off on a spending spree and live beyond their means. After all, having access to tens of thousands to hundreds of thousands of dollars can make it seem really appealing to live lavishly. But spending money you don’t have and can’t afford to repay is always a sure way to get into financial trouble, and with a HELOC that could lead to foreclosure.

Conclusion

Withdrawing or borrowing from your home equity can be a good strategy to get funds at a low interest rate. However, you have to be careful to do it wisely and keep your spending within your limits because failure to repay your debt can mean the foreclosure of your home.

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