What’s the best way to use home equity? (Podcast)

Many U.S. homeowners are equity rich

As home prices rise, so do home equity levels.

The average U.S. homeowner saw their equity increase by about $33,400 between early 2020 and early 2021 alone.

When accessed through a cash-out refinance or another loan product, that home equity could seriously improve your long-term finances and overall wealth.

Here, mortgage advisor Arjun Dhingra explains some of the best ways you can put your equity to work.

Listen to Arjun on The Mortgage Reports Podcast!

First things first: Use your home equity wisely

We’re not saying you should cash out your home equity and go on a shopping spree, or take out a high-cost HELOC for a fancy vacation.

Instead, we’re going to cover ways you can leverage that equity to actually improve your financial situation — not hurt it.

As mortgage advisor Arjun Dhingra said on a recent episode of The Mortgage Reports Podcast, “I know some of you might be thinking this sounds eerily familiar to 10 years ago, when everyone was squandering their equity on depreciating assets like boats and cars and other silly expenditures. That’s not what we’re talking about here.”

He continues, “These are responsible ways in which you can put your money to work for you constructively to leave yourself better off financially.”

With that said, here are four of the best ways to use your home equity to your advantage.

1. Use your equity for home improvement projects

Home renovations have surged in recent years, with spending clocking in at around $420 billion in 2020 alone.

With for-sale home inventory so low (and so expensive), many homeowners are choosing to remodel their existing properties instead.

As Dhingra puts it, “More and more people are realizing that they’re not really in position to sell their home, because where the market is priced, they would have nowhere to go.”

As a result, homeowners are getting creative.

They’re tapping their home equity to add space, install new appliances or smart home technologies, or update their properties to better suit their current needs. This might include adding a home office, putting in a pool or gym, or installing an outdoor kitchen or fire pit for entertaining.

Whether you use a cash-out refinance, home equity loan, or HELOC, re-investing the cash in home improvements is one of the best ways to generate a return on your investment.

2. Use equity to pay off high-interest debts

The average American has around $5,300 in credit card debt. These debts typically come with sky-high interest rates — often 18% or higher.

Fortunately, mortgage loans offer much lower interest rates. In many cases, borrowers can get rates as low as 3% (or even better if their credit score is stellar).

With a cash-out refinance, you have the opportunity to swap your high-interest debts for a low-interest one.

This is known as a ‘debt consolidation refinance.’ It can significantly reduce your monthly payments and save a lot of money in the long run, if done right. You simply:

1. Refinance your mortgage with a higher balance
2. Take the difference in cash
3. Then use that lump sum to pay down credit cards, personal loans, or other debts

This essentially rolls your higher-interest debt into your mortgage and lets you pay it off — more affordably — over time.

“The average U.S. consumer is sitting on credit card debt that might be ranging into interest rate levels that are double digits,” Dhingra said.

“Cash-out refinance rates are much, much lower than this, and in many cases, still in the 3% range. So consolidating that debt, or wrapping it into your mortgage, not only will save you money on a monthly basis, but now makes that debt tax-deductible,” he explains.

That last bit is a nice added perk.

The interest on mortgage loans may be deductible from your annual tax returns (as long as you itemize them). Interest on credit card debts, car loans, and other types of high-interest debt products is not deductible.

3. Invest your home equity

Investing in stocks, bonds, real estate, and other assets can be another smart way to use your home equity.

Think of it this way: Say you do a cash-out refinance and tap about $20,000 in equity at 3% rate. If you’re able to put that $20,000 into an index fund that yields 6% annually (the expected average over the next 10 years, according to Goldman Sachs), you could make up those costs of borrowing and earn extra cash — or pad your retirement fund — in the process.

“Some people have been pulling out equity and either increasing their contribution to their retirement accounts or putting more money into stock or other types of non-liquid holdings,” Dhingra said.

You could also consider using the cash to buy additional real estate — particularly investment properties you can use to make passive income (like rental properties, Airbnbs, vacation homes, etc.).

The cash you take out can be used for a down payment or, if you have enough equity, to buy another property outright.

This strategy could generate monthly income through rent payments as well as long-term wealth through the additional home equity you’d gain.

4. Use equity to boost your emergency fund

“COVID taught us that the unexpected can happen,” Dhingra said.

To be financially prepared for those unexpected times, it’s important to have at least six months of expenses stowed away. This allows you to comfortably get by in case of a job loss or other emergency without risking your home or other assets.

“You should be able to comfortably make six payments to cover all your bills and debts that are necessary and maintain the current standard of living that you have,” Dhingra said. “That’s what a true emergency or rainy day fund is.”

If you don’t have those six months’ worth of expenses saved up, your equity could help here. Ideally, you’d put the funds in a high-interest savings account, which would grow over time.

How do I tap my home equity?

Home equity is an illiquid asset — meaning it’s not liquid cash that you can spend. It’s tied up in the value of your home.

To convert that equity into cash, you’ll need to take out a loan against your home’s value. There are three main ways to do this:

1. Cash-out refinance — Cash-out refinancing replaces your current mortgage with a new, larger loan. The new loan is used to pay off your existing mortgage balance, and the ‘extra’ amount is returned to you as cash-back at closing (minus your closing costs)
2. Home equity loan — A home equity loan is a type of ‘second mortgage.’ That means you keep your existing mortgage in place, and take out a second, smaller loan against your home equity. Home equity loans typically have fixed interest rates
3. Home equity lines of credit (HELOCs) — A home equity line of credit is another type of second mortgage. HELOCs typically have variable interest rates and work as a revolving line of credit. That means you can borrow from your equity up to a certain credit limit, pay it off, and then borrow again throughout a set ‘draw period.’ After that you’ll have a set repayment period to pay off any remaining balance

There are pros and cons to each of these strategies. The right one will depend on your remaining loan term and loan balance, your current mortgage rate, and your personal finances.

A mortgage loan officer or financial advisor can help you pick the right loan product to meet your goals.

Put your equity to work

If you’re like most American homeowners, you’re probably sitting on a good amount of equity.

If you opt to tap it via a cash-out refinance or home equity loan, make sure you do so for the right reasons.

Just as there are many ways leveraging your home equity can improve your finances, it could hurt them as well. Avoid tapping your equity for unnecessary expenses and talk to a financial expert or mortgage advisor before making any moves. They can help you make the best decision for your household.

“It’s really important that you connect with an actual mortgage advisor on this topic — not just an everyday loan officer or e-lender,” Dhingra said.

“This is an important topic. It’s your money, and when it comes to your finances and your overall big picture of wealth, this is a key topic in which you want real, true advice.”