Homeowners have gained heaps of equity out of their property in the last several years. Despite the home price declines in late 2022, the average U.S. homeowner has an ownership stake worth around $270,000, according to CoreLogic’s “Q4 2022 Homeowner Equity Insights” report — nearly $90,000 more than they had at the onset of the pandemic.

If you’re looking to borrow money, tapping into the home equity you’ve acquired can be a lower-cost route compared to credit cards or other forms of financing. Here are the basics on taking equity out of your home, and how to do it.

What is home equity?

Your home equity is the difference between the appraised value of your home and how much you still owe on your mortgage. In a simple sense, it represents the portion of your home that you own outright.

When you buy a home, you instantly have some equity in it: an amount comparable to the down payment you made, as opposed to the percentage of the purchase price you financed. You build more home equity by making mortgage payments (which, by reducing your debt, increases your ownership stake) or by making significant upgrades and improvements that boost your home’s worth. Some homeowners also see an increase in their individual residences due to a general appreciation in local property values, either over time or as a result of sudden changes in market conditions, as during the pandemic.

Ways to take equity out of your home

There are three common ways to convert your equity into cash.

Home equity loan

A home equity loan is for a fixed amount, at a fixed interest rate, to be repaid over a set period (often 20 years). It works in a similar manner to a mortgage — in fact, it’s a type of second mortgage — in that the loan is secured, or backed by your home (or more precisely, your equity in your home).

Home equity loans typically come with a slightly higher interest rate than first mortgages. The difference is due to the lender’s position for repayment. In the unlikely event you default on the loan and your home is foreclosed, the home equity lender is able to collect through the sale of the home — but only after the primary mortgage lender recoups its money.

HELOC

A home equity line of credit is a second mortgage with a revolving balance, like a credit card, with an interest rate that varies with the prime rate. However, in some cases, lenders allow you to take out a fixed-rate HELOC.

HELOCs often come with two lending stages over a long period, such as 30 years. The first 10 years is the draw period, when the line of credit is open and you’re only responsible for making interest-only payments. The loan then converts to a repayment period of around 20 years, in which you pay back the principal and the interest.

Cash-out refinance

A cash-out refinance lets you refinance your current mortgage for more than the outstanding balance, allowing you to take the difference in cash. A cash-out refinance replaces your existing mortgage, so depending on market conditions, you might be able to get a lower rate or better terms with the new loan.

How to calculate the equity you have in your home

You can calculate the equity you have in your home by subtracting your outstanding mortgage balance from the appraised value of the property. For example, if your home is appraised at $200,000 and you owe $120,000, you have $80,000 of equity in your home.

Lenders impose a maximum amount you can borrow from your equity, often 80 percent or 85 percent of what’s available — so a new loan or a refinance makes the most sense if the value of your home has increased or you’ve paid down a significant portion of your mortgage. They also assess your loan-to-value ratio (LTV) or how much you still owe on your mortgage, vis-à-vis your home’s worth.

Calculating loan-to-value (LTV) ratio

To calculate your loan-to-value (LTV) ratio, take the amount of your existing mortgage and divide it by the appraised value of your home. Using the above example, you would divide your mortgage balance ($120,000) by your home’s appraised value ($200,000) to find your LTV: 60 percent.

An LTV of 60 percent means you have 40 percent equity in your home. At this LTV (and assuming you meet the lender’s other requirements), you’d likely qualify for a refinance or home equity loan.

Benefits of taking equity out of your house

One of the primary benefits of tapping home equity when you need a significant amount of money is that you can often access cash at far lower interest rates than with personal loans or credit cards. When you need to cover large expenses such as home renovations, college tuition or debt consolidation, using home equity can be a less expensive way to obtain the funds.

“It’s often the cheapest form of financing available for homeowners,” says Vikram Gupta, executive vice president and head of Home Equity at PNC Bank. “Because the loan is secured by the house, lenders can offer it at a lower rate compared to other consumer lending products.”

Tapping your home’s equity can also offer greater flexibility. HELOCs and home equity loans often have multiple terms and repayment options to choose from. There are also few restrictions, and you are free to use funds as you wish.

Another benefit of accessing money this way: The interest you pay on a home equity loan or line of credit might be tax-deductible. The deduction is generally allowable if you use the money to “buy, build or substantially improve” your home, according to the IRS. You must also itemize deductions on your tax return.

Risks of taking equity out of your house

While taking equity out of your home does have advantages, it’s not without risk. The primary downside is that your home is used as collateral for the debt.

“What that means is that if you are unable to make the monthly repayments for a sustained period of time, there is a risk that the lender could foreclose on (repossess) your house,” says Gupta.

Not only could you lose your home and all the equity you’ve built up, but a foreclosure could have other repercussions:

• Your credit score could drop by at least 100 points or more.
• A foreclosure will remain on your credit report for seven years from the date of the first missed mortgage payment.
• A lender might not allow you to borrow money for several years (generally, borrowers must go through a waiting period after a foreclosure before being able to qualify for a mortgage).
• You could end up with a deficiency judgment, which is a court order allowing a lender to collect additional money from you. The lender could garnish your wages, put a lien on any other property you own or levy your bank accounts.

Another concern often associated with taking equity out of your home is the potential for a downturn in property values, reflecting  amid a downturn in the real estate market.“If home values in a given market are declining, borrowers run the risk of owing more than what the home is worth,” says Jason Salcido, assistant vice president, Digital and Lead Acquisition Sales for PenFed Credit Union.

Which home equity option is right for me?

The best home equity option depends on what you’ll be using the funds for and whether you know the exact amount you need to borrow. Let’s consider the following scenarios:

• Debt consolidation: To refinance high-interest debt, it’s best to take out a home equity loan. That way, you could borrow the exact amount you need to pay off those outstanding balances on credit cards or other loans. In addition, you’d have fixed monthly payments at a fixed interest rate, which could be easier to budget for. If you took out a HELOC, your monthly payments could increase, making it harder for you to repay if you’re on a fixed budget.
• Higher-education expenses: A HELOC might be a better option for college tuition. You know these bills will occur regularly for four years, once or twice a year. So, withdrawing the funds for them on an as-needed-basis might make more sense, especially since you’ll only accrue interest on the amount you actually borrow.
• Home improvements: Can go several ways, depends on the project and whether you know how much you need to borrow. If it’s a single item or project — a new HVAC system or swimming pool — consider getting a home equity loan or doing a cash-out refinance. If you’re working on a multi-phase remodel that has ongoing costs and an indefinite timeline, a HELOC would be best. That way, you can pay the contractors in installments, have reserves to draw on if the project goes over budget.

5 ways to increase your home equity

If you want to borrow from your home equity but don’t yet meet your lender’s requirements, there are a few ways to increase the amount of equity you have:

1. Put more toward your mortgage

The single most effective way to increase your home equity is to pay off your mortgage sooner. If you can’t afford to pay off your remaining mortgage in full, try making larger monthly payments, or even just a few extra payments per year. Not only will that help you build home equity faster, you’ll also save thousands of dollars in interest. Before you do this, check with your lender to make sure there isn’t an early-payment penalty.

• How this affects equity in your house: Making extra payments to your mortgage principal is the most straightforward way to increase your home equity. Every dollar you pay early toward your mortgage is one dollar of home equity increased.

2. Increase the value of your home

Another way to build home equity is to increase the value of the property. For instance, you could add rooms or expand the living spaces; enhance the  landscaping, or add solar panels or other technology to make your home more energy-efficient or “green.” Before deciding to spend on a remodeling project, make sure the improvements generally have a high return on investment (ROI), such as fixing up the kitchen, upgrading the garage or replacing the roof.

• How this affects equity in your house: By increasing the value of your home, you can increase your home equity, even without changing the amount that you owe. When taking this approach, remember that overall market conditions can have an effect on your home’s value and not all renovations will increase the value of your home or provide the same amount of return.

3. Refinance to a shorter loan

If you can afford to make higher monthly mortgage payments, consider refinancing to a shorter-term loan. For example, if you currently have a 30-year mortgage, think about switching to a 15-year mortgage so you can pay off your mortgage sooner and build home equity at the same time.

However, keep in mind that refinancing your mortgage to a shorter term will increase your monthly payments, so make sure you can afford to cover the added cost. Refinancing also comes with closing costs just like a regular mortgage. Some lenders offer no-cost refinancing, which means closing fees are wrapped into your mortgage loan.

• How this affects equity in your house: When you refinance to a mortgage loan with a shorter term, you’ll pay less interest overall and with your monthly payments. That means more of each monthly payment goes toward paying down your mortgage principal, which increases your equity.

4. Improve your credit score

Although building your credit score won’t necessarily boost your home’s equity, it could give you the opportunity to take out more money. Regardless of how much equity you have, if you have a poor credit score, you’ll be limited in the amount you can borrow. Lenders view homeowners with bad credit scores as high-risk, less likely to be able to repay a loan. Paying your bills on time and keeping credit card balances low can help improve your score.

• How this affects equity in your house: Improving your credit score won’t directly affect your equity, but it does have an impact on what kinds of home equity loans you might qualify for. If you’re able to raise your credit score, you might be able to take out 80 percent of your equity instead of only 70 percent, for example. You might get a better interest rate, as well.

5. Take advantage of market fluctuations

Granted, this is a less proactive approach, but real estate markets change over time, and your home value fluctuates accordingly. As demand grows and home prices increase, the value of your home rises. As a result, your home equity increases.

Though this approach is out of your hands, you can be proactive by regularly monitoring and checking the value of your home on listings sites like Zillow and Redfin.

• How this affects equity in your house: The value of your home, and thus the equity you have in it, is impacted by market forces such as increased demand. Regularly monitoring the value of your home will help you stay informed, so you’ll have a general sense of your home’s worth and be ready to act when the time is right.

Other considerations when getting a home equity loan

If you think you’re ready to use your home equity, keep the following in mind:

• Home equity rates are relatively low. HELOC and home equity loan rates are much lower than those for credit cards and other types of loans, and they might be easier to qualify for. This is because home equity loans are secured loans, meaning they are backed by collateral (your home, in this case).
• Home values can fall. One reason to be careful with home equity loans is that home values fluctuate. If you take out a big loan and the value of your home drops, you could end up owing more than what your house is worth. This is known as “upside-down” or “underwater.” The housing crash of 2008 left millions of borrowers stuck in homes they could not sell because the value of their homes sank and their mortgage debt was  more than their homes were worth.
• Your house is on the line. If you bought your house or refinanced when rates were low, you have to ask yourself how wise it is to do a cash-out refinance, especially if the rate you’re now borrowing at is considerably higher than that of your existing mortgage. If you fall behind on payments, you’re at risk of foreclosure.

Next steps

If you’re considering borrowing equity from your home, the next step is to approximate how much your home is worth. Then, take your existing mortgage balance and divide it by your home’s value to figure out if you might be eligible for a home equity loan or refinance.

Then, develop a plan that addresses why you want to take equity out of your house and how and when you’ll pay it back. It’s best if you only take equity out of your home for a specific purpose that has a positive financial payback. This could be anything from consolidating other debts with a lower interest rate to improving your home’s value through a major home improvement project.

Finally, whether a HELOC, home equity loan or cash-out refinance, shop around with a few lenders to get the process started. Check out Bankrate’s reviews of home equity lenders as you compare.