As interest rates fall and home prices rise, people with equity in their homes often think about using this wealth to take cash out of the house. That is commonly known as “taking money out of your house” or “cash-out refinancing.”
The interest rates are at historic lows. The cost of borrowing on a home equity line has never been cheaper, so why not take advantage of it? But this is often the wrong move.
Instead, it would help to use your home equity to borrow less, not more. If you have a mortgage on your home, consider making extra payments to pay it down faster and save thousands of dollars in future interest costs.
Do I Have Home Equity?
Home equity is the difference between what your home is worth and how much you owe on it. Homes in Canada are often substantial investments. Consequently, this can mean a substantial amount of money in your pocket.
For instance, if you bought a house for $250,000 five years ago, but its market value has increased to $275,000 due to rising house prices, your home equity is $25,000. That’s all the money you have in the bank if you sold your home or paid off your mortgage.
What Happens When You Take Cash Out of Your House?
When you cash out part of your equity by refinancing your mortgage, you take a loan against it. The line of credit that you get access to at your bank is equal to 80% of the amount they approve. So if you need $10,000, you should expect them to give you a line for up to $8,000 maximum. And this line also carries an interest rate based on prime minus 0.15%.
Let’s say prime is currently 3.75%, and your home equity line is at prime minus 0.15%, or 2.65%. So if you take a $10,000 loan from the bank, they will charge you interest on this money of about $23 per month for two years.
If you use home equity to get cash out of your house, you have to earn more than $30,000 within two years to break even! Every dollar below that is pure profit for the bank.
But wait a second, why would someone want to borrow on their home equity so expensively when they could go to their local bank and get a personal line of credit for 9% fixed interest? The biggest reason is that the bank won’t give them as much credit.
Home Equity Loans vs. Personal Loans
The bank wants to protect itself from the risk that you’ll stop paying them back, so they give you a loan based on 80% of your home equity. That is because if you stop making payments, then the bank forecloses and takes ownership of your house.
If this happens, your line of credit will be gone because they have seized it for repayment and everything else in the house.
So while that 9% line is cheaper than taking out money against home equity, it’s still expensive compared to personal loans. The best way to use home equity is not as cash-out financing but instead as a second mortgage to increase your monthly income.
Second Mortgage vs.Taking Out Cash
A second mortgage means that you agree to borrow against your home’s equity but with no immediate plans to use the money for any specific purpose. Instead, it gives you access to extra cash whenever you need it.
If you want to take out $10,000 in cash from your home equity line, then you can get it right away. But this means that you will be charged interest every month until the two years are up to when the loan matures.
Instead of doing this, you can use a second mortgage to access extra cash in amounts that suit your needs. That leaves you with more flexibility because you don’t have an arbitrary repayment schedule imposed by the bank.
Advantages of Home Equity Loans
Home equity loans aren’t just for taking out $10,000 cash against your home. They’re also great for getting approved for high amounts of credit at low-interest rates, so you can take out lots of extra cash whenever you want.
The second mortgage is paid back according to the same terms as your primary personal loan. That’s why it’s not uncommon to find yourself with much higher limits than usual on this kind of financing. Having an additional line like that allows you to keep more money in reserve if you need it down the road.
Two ways having an open home equity line has certain advantages, including:
- Your home is an asset, which means you can use equity finance renovations. That way, you can increase the value of your home and sell it later when you need cash.
- If you have an open line of credit, then it’s the cheapest way to borrow large amounts that suit your needs right now.
- No one can predict when they’ll lose their job or fall ill, so it’s essential to be prepared for the possibility of needing lots of cash at once. What separates home equity loans from other forms of finance because they are designed for this kind.
Use Home Equity Carefully
Having a home equity line of credit is what many people use to borrow cash when they want it right away. But doing the same with a second mortgage won’t save you any money, so you should only use this method when you are confident that the extra banked interest will benefit you over time. Because there’s no penalty for taking out money whenever it suits your needs, getting an open second mortgage can be an easy way to increase your income while protecting yourself against emergencies.
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