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Personal Finance > Loans

Loans

The Best Ways to Use Home Equity

By Joan Pabón MONEY RESEARCH COLLECTIVE

August 11, 2022

Home prices in the United States have increased by more than 40% since the start of 2020. This means many homeowners have considerable home equity they can tap into — about $207,000 on average, according to estimates by data provider Black Knight.

If you’re one such homeowner looking to get equity out of your home, there are three ways to do so (besides selling your property): getting a home equity loan, a home equity line of credit (HELOC) or a cash-out refinance loan.

In this article, we briefly explain what home equity is and how it works, and also break down the best ways to access it.

What is home equity and how does it work?
4 best ways to use home equity
Ways to use home equity FAQ
Summary of our guide on how to use home equity

What is home equity and how does it work?

Simply put, home equity is the value of your property minus what you still owe on your mortgage. You build equity in your home when you put money down to buy the property, and the equity keeps growing as you make monthly mortgage payments. If your home increases in value, as most properties have in recent years, that appreciation in value further adds to your home equity.

Once you have sufficient equity to tap — meaning the equity available to you minus a 20% of the value that lenders generally require you to reserve — you can access it through a loan or line of credit, and use the proceeds for various purposes.

Types of home equity loans

Again, there are three types of loan products that can help you access your home equity. All of them have pros and cons.

Home equity loans

Home equity loans, also called second mortgages, are fixed-rate loans that offer borrowers a lump sum payment from their accrued equity. These loans are secured by the borrower’s home, but they don’t modify your existing mortgage loan, if you have one. Borrowers who are close to paying off their first mortgage or own their home outright and don’t want to refinance their mortgage may opt for a home equity loan instead.

Home equity loans generally feature lower rates than credit cards and personal loans because — as they use your home as collateral — they’re a safer investment for lenders. And since interest rates are fixed, they’re also a safer alternative for borrowers who want predictable monthly payments.

Home equity lines of credit

HELOCs are a form of revolving credit, not unlike a credit card, that borrowers can use as needed — up to the credit limit they’ve been approved for. Unlike credit cards, however, lines of credit feature a draw period that generally spans the first five to 10 years of the loan term. During that time, homeowners can either repay what they borrow in full or make interest-only payments.

The draw period on a HELOC is followed by a repayment period that can last anywhere between 10 and 20 years. During the repayment period, the borrower can no longer draw from their line of credit and must make principal and interest payments on their outstanding balance. And as the majority of HELOCs feature variable interest rates, monthly payments can change from month to month.

The flexibility of a HELOC makes them a good fit for borrowers who have expenses that will span several years (like home improvements) or want to keep an emergency fund.

Cash-out refinance

Refinancing entails replacing an existing mortgage with a new one featuring a different loan term, loan amount and/or a new interest rate. In the case of a cash-out “refi,” your new loan is for a larger amount than your original mortgage, and you receive the difference in cash.

Refinance loans have closing costs and fees, so this option might not make financial sense for every borrower, especially not those who are close to paying off their mortgage.

For more information on different types of loan options, read our guide on the best home equity loan lenders.

Pros and cons of tapping into your home equity

All three loan products that allow you to access your home equity have particular advantages and disadvantages. The main thing to keep in mind is all of them use your home as collateral — so you could lose your property if you can’t repay your loan or end up with negative equity (as in an underwater or upside down mortgage for which you still owe more than you would receive for the property if you sold it).

The funds can be used for anything you need
Home equity loans may have lower interest rates than credit cards and personal loans
Some home equity loan options have low closing costs
A home equity loan can help you increase your equity through home improvements
Interest on home equity loans and HELOCs could be tax deductible, if used for home improvements

Failure to keep up with your loan payments could result in foreclosure
You could deplete your home equity, and end up underwater on your mortgage
Some loan options have variable rates, so payments could change month to month
Lenders set a limit on the amount of equity you can access, so not all borrowers qualify

4 best ways to use home equity

1. Home improvements and renovations

Home equity loans are often used to fund home improvement projects. Since investing in home improvements can increase property value, this helps you build equity at the same time. And you don’t need to do a full home renovation to reap the benefits either. Simple home upgrades such as adding a deck or boosting your home’s curb appeal can considerably increase the resale value of your home.

You could also invest in upgrades that can save you money in both the short term and the long run, such as energy-efficient appliances, a solar power system or an updated HVAC system.

As an added perk, the interest on your home equity loan, HELOC or second mortgage could be tax deductible — provided the loan is used to buy, build or “substantially improve” your home. Under the Tax Cuts and Jobs Act of 2017, the interest on these types of loan products is tax deductible until 2026, and that applies to combined loan amounts of up to $750,000 (or $375,000 for married taxpayers filing separately).

2. Debt consolidation

Many borrowers also choose to tap into their equity to pay off high-interest debt, such as credit card debt or private student loans. And since some home equity loan options have competitive interest rates, you could get out of debt faster and pay less interest overall.

If you’re in a debt trap caused by unnecessary spending or lack of savings for emergencies, consolidating your debt with a home equity loan won’t address the root of the problem — but free financial counseling could help.

3. Setting up an emergency fund

If you don’t have immediate need for funds but want to make sure you’re covered in the event of an emergency, you could take out a home equity line of credit. These products allow you to draw from your home equity as needed and either repay what you’ve borrowed or make low interest-only payments on those draws.

If you’re getting a HELOC for this purpose, know that some lenders charge an inactivity fee if you’re not using your account regularly. Also keep in mind that lines of credit generally have variable rates. Depending on your financial situation, you may want to look for lenders that allow you to lock your HELOC rate or opt for a home equity loan instead.

4. Purchasing an investment property

Home equity loans tend to have lower interest rates than investment property loans — and may have lower closing costs as well. Of course, you may not be able to purchase an investment property with a home equity loan alone, but a loan might allow you to make a larger down payment. And putting more money down can help you increase the equity in your investment property, lower your interest rate and monthly payment, and pay off your loan faster.

When considering this option, first evaluate whether your real estate investment is likely to pay for itself in the near future. There are different methods for calculating your return on investment in real estate. For example, you may take into account your potential gains and subtract all costs related to the property, including the purchase price and any repair costs. Alternatively, if you’re financing the property, you may calculate your out-of-pocket expenses only (the down payment and repairs for example), leaving out the purchase price. Note, however, that these methods don’t take into account future property taxes or operating costs.

For more information on how to calculate the return on investment on a second property, read our article on using home equity to buy another house.

Also, contemplate the possible financial implications of having three loans (your first mortgage, a second mortgage and third form of financing) if your home equity loan is not enough to fund the purchase.

Other uses

There are no limits to how you can use home equity loans. Many wonder whether they can use the money to pay off their mortgage, pay college tuition or cover the costs of starting or growing a small business. And the answer is yes, you can use the equity in your home for any of those purposes.

We did not include these among the best ways to use home equity because they may not make sense for most borrowers.

Paying off your mortgage – Whether or not taking on a second mortgage to pay off a first mortgage makes sense will depend on the interest rate you’re offered as well as potential closing costs and other loan fees. In most cases refinancing might be the better choice, especially if your main objective is to lower your monthly payments.
Paying for college – Home equity loan rates may be more competitive than private and unsubsidized federal student loan rates. Still, there are many advantages to choosing a student loan instead. For example, student loans don’t have closing costs and you are not in danger of losing your home if you can’t repay your loan. Additionally, student loans offer different repayment options, including income-driven repayment, deferment and forbearance.
Starting or growing a business – Again, interest rates on home equity loans may be lower than those for other business financing options, but the risks of using your home equity for this purpose are considerable. According to the Bureau of Labor Statistics, many startups go out of business soon after they open. With this in mind, borrowers should be careful about using their home as collateral to fund a business venture that could fail and potentially leave them without a source of income and with nowhere to live.

Ways to use home equity FAQs

What is the best way to use home equity?

One of the most popular ways to use home equity is to invest in home improvements that can increase the value of the home and put equity right back into the property. Another advantage to using a home equity loan or line of credit for this purpose is that the interest on your loan could be tax deductible.

What can home equity be used for?

There are no limits to how you can use a home equity loan. You can consolidate or pay off debt, invest in home improvements or a rental property and cover day-to-day or emergency expenses. Just make sure you understand the risks and long-term financial repercussions of getting a loan that's secured by your home.

Can you use the equity in your home to pay it off?

Yes, you can pull out equity from your home using a home equity loan or line of credit and use it to pay off your existing mortgage.

If interest rates are lower now than when you took out your mortgage, taking on a home equity loan could serve the same purpose as refinancing your home loan to get a lower rate of interest. But whether or not this makes financial sense will depend on current home equity loan rates and refinance rates, as well as potential closing costs and fees associated with either option.

While HELOCs don't give you access to a lump sum of money, they do allow you to draw funds over a predetermined period. This means you could use a line of credit to pay down your mortgage balance and make interest-only payments on the amounts you use during the draw period. Nevertheless, the risks of this strategy could outweigh its rewards, as HELOCs typically have variable rates that rise along with the prime rate. If rates hike and you haven't made any payments toward your principal balance, your monthly payment could increase substantially or become unaffordable.

What can you do with positive home equity?

You have positive equity when the value of your home exceeds what you still owe on it. But having positive home equity doesn't mean you can access it right away. Most lenders require you to have a combined loan-to-value (CLTV) ratio of under 80% to qualify for a home equity loan, meaning you would need to have at least 20% equity in your home.

Besides having sufficient tappable equity, most lenders require borrowers to have a good credit score, stable income and a low debt-to-income (DTI) ratio, among other things. But if you qualify for a home equity loan, there are no limits to how you can use the money. One of the most popular ways to use equity, and one that can have tax benefits, is making improvements to your home.

What is the difference between equity and debt?

Debt is something (often money) you owe someone else and have the obligation to repay. A mortgage loan, for example, is a debt you owe your mortgage lender. When you finance a home through a bank or other financial institution, you are borrowing money you'll have to repay with interest over a loan term. If you're unable to repay your loan, the bank can seize your home and sell it to offset its losses.

Equity can be seen as the opposite of debt, since it's a financial asset rather than an obligation. At the start of your mortgage, the share of your home that you own is small, but your ownership increases as you start making payments on your loan. This is called equity, or the value of your home minus what you still owe on your mortgage.

What are the benefits of using home equity?

Pulling equity from your home can give you the funds you need to make necessary home repairs, cover emergencies, fund investments and for virtually anything else you wish. Home equity loans also tend to have lower rates than other funding options. And if you take out a home equity loan to make improvements to your home, you're putting equity right back into your home by increasing the value of your property.

What are some other ways you can use home equity?

Besides making improvements to your home, consolidating debt, setting up an emergency fund and purchasing an investment property, you could also use home equity to fund a new business venture, pay for college, cover emergency expenses, buy energy-efficient appliances or anything else you can think of.

Does it cost a lot to use home equity?

Home equity loan rates are pretty competitive with those of other loan options. However, there are other costs associated with these types of loans, like closing costs (between 2% and 5% of the loan amount) and fees (some lenders charge annual fees, inactivity fees and even draw fees).

For example, most lenders require an appraisal of your home as part of their qualification requirements for a home equity loan or line of credit. And while appraisals can cost between $300 and $500, some can cost as much as $2,000. Nevertheless, some lenders are willing to cover the appraisal and other closing costs.

Summary of our guide on ways to use home equity

If you have between 15% and 20% equity in your home or have already paid off your mortgage, a home equity loan, HELOC or cash-out refinance loan can help you access the equity in your property. And you can use those funds for a number of things, from updating and upgrading your house to paying off debt and setting money aside for unforeseen expenses.

While you could use a home equity loan for anything you wish, including funding investments and business ventures, you should consider the risk of defaulting on your loan and losing your home – which can be all too real. As with any kind of financing option that’s secured by your most important asset, your home, consider your options carefully and have a clear picture of your short and long term financial situation before making a decision.

Joan Pabón

Joan is a professional translator, writer and editor with a special interest in personal finance and insurance topics. She has been a contributing author and independent researcher at ConsumersAdvocate.org since 2017 and an editor at Money since 2019. Her work has been featured in MSN Money and Apple News.