Home equity options and how they differ

Home equity is the portion of your home's value that you own outright. It is usually described as the difference between what the property would likely sell for and what you still owe on any loans secured by it. As you pay down a mortgage, or as local property values change, your equity may rise or fall. Many homeowners eventually wonder whether that equity can be put to work, for example to fund renovations or consolidate other debt.

The common ways to borrow against equity differ more than their names suggest. This guide explains how each typically works.

What lenders typically look at first

Lenders usually order an appraisal or a valuation to estimate what the home is worth, then compare that figure with the balances you already owe. Most lenders will not let you borrow against the full value of the home and keep a margin as a cushion. They also tend to review your credit history, your income and your existing monthly obligations. Limits differ between lenders and can change with market conditions.

Home equity loans

A home equity loan is often called a second mortgage. You receive the money as a single lump sum and repay it in regular instalments over a set period. The interest rate on these loans is frequently fixed, which means the payment usually stays the same from month to month. That predictability may appeal to someone with a defined, one-time expense.

The trade-off is flexibility. You begin paying interest on the entire amount from the start, even if you do not need all of it right away. Closing costs and fees may apply and vary between lenders.

Home equity lines of credit

A home equity line of credit, commonly called a HELOC, works more like a credit card secured by your home. The lender approves a maximum amount, and you draw from it as needed during what is usually called the draw period. You typically pay interest only on what you have actually borrowed. When the draw period ends, a repayment period begins, and you can no longer take new advances.

Many lines of credit carry a variable rate tied to a published index, so the payment may rise or fall over time. Some allow interest-only payments during the draw period, which can make the payment noticeably larger once repayment of principal begins. Ask how the rate is calculated, whether there are caps on how far it can move, whether there are annual or inactivity fees, and what happens to the payment when the draw period closes.

Cash-out refinancing

A cash-out refinance replaces your existing mortgage with a new, larger one. You receive the difference in cash at closing. Because this is a full refinance, it usually involves a new application, an appraisal and closing costs similar to those of an original mortgage.

The key point is that the new terms apply to your entire mortgage balance, not just the cash you take out. If the rate on the new loan is higher than the rate on your current one, you may end up paying more interest on money you had already borrowed. A cash-out refinance may also restart your repayment schedule.

Reverse mortgages

A reverse mortgage is designed for older homeowners who meet age and eligibility requirements. Instead of making monthly payments to a lender, the borrower receives funds, and the balance grows over time. The loan typically becomes due when the borrower sells the home, moves out permanently or passes away. Borrowers generally remain responsible for property taxes, insurance and upkeep, and failing to keep up with those obligations can put the home at risk.

Some types require counselling from an approved counsellor before you apply, and because they affect what may pass to heirs, many people involve family members.

Risks that apply to every option

Beyond that central risk, borrowing against equity reduces the cushion you would have if property values fell or if you needed to sell quickly. Using home equity to pay off unsecured debt, such as credit cards, can lower interest costs in some cases, but it also converts debt that was not tied to your home into debt that is. Whether the interest on home equity borrowing is tax-deductible often depends on how the money is used and on current tax law, which changes. A tax professional is the right person to confirm how the rules apply to you.

Questions worth bringing to a lender

• Is the rate fixed or variable, and if variable, which index is it tied to and how often can it change?
• What closing costs, origination fees, appraisal fees or annual fees apply, and is there an early closure fee?
• For a line of credit, how long is the draw period, and how will the payment change when it ends?
• For a refinance, how does the total cost over the life of the new loan compare with keeping my current mortgage?