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Homeowners Are Tapping Their Equity. Should You?

Janna Herron
Homeowners Are Tapping Their Equity. Should You?

After five years of rising house prices, more homeowners are unlocking some of that value to put toward renovations or to consolidate high-cost debt.

The share of cash-out refinances—when a borrower takes out a new mortgage for more than the original and pockets the difference—hit the highest level in nine years at the end of last year, according to Freddie Mac. The uptick is fueled by the growth in home equity, which has more than doubled since 2012, according to CoreLogic. Last year alone, the average homeowner gained $15,000 in equity wealth.

Describing his mix of mortgage business now, Scott Sheldon, branch manager of New American Funding in California, says: “I’m about 50% refinances now, and all but one is cash out.” He sees no signs of cash-out activity slowing, either.

Here’s a rundown of what’s driving the trend, along with advice on how to join it—and on some alternatives you should consider before tapping your home equity through refinancing.

What’s driving cash-out refinancing

While the sharp growth in equity has enabled more homeowners to seek cash-out refinancing, there are two main reasons driving the practice: home improvement and debt consolidation.

Improving rather than moving: Spending on home improvements and repairs is expected to jump by 7.5% this year, the largest year-over-year gain since 2007. The more common projects such as bathroom and kitchen remodels, roof replacement and deck additions can easily run into the tens of thousands of dollars—cash that many homeowners don’t have on hand.

Historically, cash-out refinances are often used to fund those remodeling projects. The cost to borrow is often lower—interest rate-wise—compared with credit cards, personal loans, equity installment loans or lines of credit. With home prices up by 46% since 2012 and mortgage rates still historically low, this time around is no different.

“Equity has substantially increased and people are seeing that they may want to improve or upgrade,” says Pava Leyrer, chief operating officer of Northern Mortgage, “as opposed to trying to find a house [in a market with] limited supply right now, even if they could sell theirs quickly for more.”

Mortgage rates remain attractive: Other homeowners who are cashing out are looking to eliminate higher cost debt—and with good reason, too. Outstanding revolving balances—largely credit card debt—again hit a record high in January, while student and auto loan debt grew by 5.6%. Even as mortgage rates rise, they remain attractively low and are cheaper than rates on other debt.

“If the blended interest rate of all cumulative debt—car loans, credit cards, mortgages, student loans—is 5.5%, but you can get a cash-out refi at 4.5%, then that’s financially beneficial,” says Sheldon.

Do you qualify?

You can only cash out if you have enough equity built up in your home. “If you bought a few years ago with only 5% to 10% down, you may not have enough equity to qualify,” says John Stearns, a senior mortgage loan originator at American Fidelity Mortgage in Wisconsin.

You must also meet credit score and debt-to-income requirements, which differ depending on the type of cash-out refinance you receive. If you only make the minimum credit score, your mortgage rate will likely be up to a half-point higher and you’ll pay more in closing costs, says Sheldon.

Loan type Max loan-to-value Minimum FICO score Max debt-to-income
Fannie Mae/Freddie Mac 80% 620 50%
FHA home loan 85% 580 54.9%
VA home loan 100% 580 54.9%

The refinance process

Getting a cash-out refinance is practically like taking out a mortgage to buy a house—and requires the same amount of patience and paperwork. Be prepared to provide the following documents to the lender:

  • Two years of most recent tax returns
  • W-2s from previous two years
  • 30 days of paystubs
  • Two months of bank statements
  • Asset statements for last 60 days; if quarterly, for the last two quarters

The lender may also require a letter detailing how you intend to use the money from the refinance, says Stearns. This is a federal reporting requirement for the lender, but it doesn’t factor into the approval. Whatever your reason is, Stearns says, it "won’t deny you the refinance." You also must pay for closing costs, which include underwriting expenses, an appraisal, and credit report costs. These are typically wrapped into the loan balance, rather than paid out-of-pocket.

Alternatives to cash-out refinancing

There are two other ways to tap your home’s value: home equity lines of credit (HELOCs) and equity installment loans. These could be a better option, depending on your circumstances.

HELOC: Lines of credit are typically less expensive to originate than cash-out refinances, and you can keep the unused line open for future needs. The downside is that the interest rate on a HELOC is variable and often tracks any movement in the federal funds rate, which is expected to increase up to three more times after this week’s quarter-point hike. That will make interest charges on HELOCs more expensive down the road.

Equity loan: These are also less expensive than getting a cash-out refinance—often with lenders offering a free appraisal—and come with a fixed interest rate, unlike HELOCs. But equity loan rates generally are one to two percentage points higher than rates on cash-out refinances because loans are a second lien—rather than a first—against your home.

Tax consequences

Thanks to the new tax reform bill, the deductibility of mortgage interest has been narrowed and could affect how you tap your home equity. Mortgage interest from cash-out refinances remains deductible in all cases. But you can only deduct interest from HELOCs and home equity loans if the proceeds were used for home improvement or toward the purchase of a new home. If you used the HELOC or loan funds to pay off debt, you can’t write off the interest.