Many financial professionals find themselves fielding questions from clients about accessing cash to pay for major expenses. Tapping into home equity remains a popular way to cover various needs, from home improvements, college costs and medical bills to consolidating credit card debt.
The appeal of home equity financing depends primarily on rising home values and low interest rates. Home value growth is expected to continue, but today’s environment of high inflation and rising interest rates is shrinking consumer spending power. And federal rate hikes to control inflation have already begun, which typically means higher mortgage rates, making home equity financing costlier.
Certain financing options may be less attractive than they were a few months ago, while others still retain their appeal. Four of the most common types of equity financing are home equity loans, home equity lines of credit, mortgage refinancing and home equity investments. Each has pros and cons when considering broader economic conditions and your clients’ overall financial picture.
Home Equity Loan
Home equity loans allow homeowners to borrow a lump sum for large, planned expenses, such as home upgrades. Homeowners need good credit scores, enough income to qualify and funds to cover closing costs—typically 2% to 5% of the overall loan amount. Interest rates for home equity loans are fixed.
As of August 2022, rates range between 3% and 12% depending on borrowers’ qualifications. If federal rate hikes continue, these rates could also increase. Homes are used as collateral in equity loans, so homeowners should ensure they can afford monthly repayments until the loan balance is fully repaid.
Home Equity Line of Credit (HELOC)
With HELOCs, homeowners can draw amounts from their equity (up to the maximum approved amount) to pay for large ongoing expenses, such as college, or unplanned expenses, such as unexpected home repairs or medical expenses. Good credit and minimum income requirements also apply to qualify for HELOCs, and homeowners must pay closing costs.
Interest rates for HELOCs are variable, which could cost borrowers more if mortgage rates rise. Set monthly payments are owed only on the amount they draw down. But, like home equity loans, HELOCs use the borrower’s home as collateral, so homeowners should borrow only what is necessary and keep up with monthly repayments. In addition, HELOCs pose an additional risk if the borrower’s home decreases in value, thereby shrinking their line of credit—and their financial cushion.
A “cash-out” mortgage refinance allows homeowners to pay off their first mortgage and replace it with a new mortgage, typically at a lower fixed interest rate. They receive a lump sum of cash equal to the difference between the two loans. But closing costs and fees for cash-out refinances are higher than for home equity loans, or HELOCs, because lenders must generate an entirely new mortgage. Still, cash-out refinances provide a way to use equity without taking on a home equity loan, which is essentially a second mortgage. However, with overall mortgage interest rates rising, finding a lower interest rate on an existing mortgage in the current market may prove challenging.
Home Equity Investment
Home equity investments offer a lesser-known but innovative way to tap into equity. They allow homeowners to get cash upfront in exchange for a share of their home’s future value, and the home secures the investor’s interest. Qualification requirements differ from those of traditional refinancing, and homeowners do not need to worry about monthly payments or interest charges with an equity investment—just appraisal costs, origination fees and closing costs. To settle the investment, homeowners buy the investor’s share after a set period of 10 to 30 years or whenever they decide to sell or refinance their home before that time.
Unlike financing options that include specific criteria for how the funds are used, home equity investments allow homeowners to use the funds for any reason, making it a flexible option. Some use the cash for small business opportunities, diversifying their portfolio, eliminating debt or paying for college tuition, but the possibilities don’t stop there.
Here are four more ways your customers can use home equity investments:
- Vacation home purchase
Home equity investments can provide the cash for a down payment and closing costs for a vacation home. Most home equity investors today do not distinguish between a vacation home or investment property or restrict how funds are used.
- Home renovations for a future sale
Home equity investments may be a smart way to fund renovations that increase a home’s value for a sale down the road, especially for homeowners with ample home equity but subpar credit scores. With the upfront cash, they can cover that basement conversion or new flooring without adding to their debt load.
- Alternative to a bridge loan
Homeowners use bridge loans for short-term cash to buy another home before selling their current one or for the costs of flipping a property. However, bridge loans typically come with high interest rates and origination fees. A home equity investment may be an appealing alternative to a traditional bridge loan. Funding an equity investment takes as little as a few weeks compared with a few days for a bridge loan, but home equity investments could be a smart alternative if homeowners do not need the cash as urgently.
- Real estate investing
Investing in real estate and building a portfolio can help generate passive income and diversify assets. However, getting started comes with a hefty price tag for down payments, closing costs, insurance and potential repairs. A home equity investment can help finance an investment property without the stress of interest, monthly payments or more debt.
Inflation and higher interest rates make it more difficult for homeowners to absorb the costs associated with traditional equity financing. Certain refinancing options may be less attractive than a few months ago, so it is important to consider high inflation and evolving interest rates when recommending different options. With home equity investments, your clients can still benefit from tapping into their equity for those large expenses without the stress of monthly payments, interest costs or debt.
Gregg Damiano is director of channel sales for Hometap.