Key takeaways
- Even after you’ve paid off your home, you can still borrow against your home’s equity.
- There are several ways to tap your equity when you’re mortgage-free, including with a home equity loan, HELOC or cash-out refinance.
- It can be easier to qualify for a loan on a paid-off house, but you face the risk of losing your home if you can’t repay it.
You finally own your home free and clear. And now, you want to put that ownership stake to use. Is this even possible?
Fortunately, the answer is yes. You can take equity out of your home even after your mortgage is paid off. One of the easier ways to do so is to sell your home. But there are also financial products that allow you to extract equity from your paid-off home quickly without having to pick up and move.
So let’s look at the options for getting equity out of a house you own outright.
Can you take equity out of a paid-off house?
“It is definitely possible to take equity out of your home after you’ve paid off a previous mortgage,” says Jeffrey Brown, a Seattle-based mortgage professional with NEXA Mortgage. “Assuming you qualify, you can access that equity at any time.”
Actually, those means of access are pretty much the same for a paid-off house as for one that still has a mortgage on it. You can take equity out of your home using one of these tools:
- home equity loan
- home equity line of credit (HELOC)
- reverse mortgage
- cash-out refinance
- shared equity investment
How much equity can I to cash out of my home if it’s fully paid off?
More than if you had a mortgage, that’s for sure. Home equity equals the market value of your home, minus any debt attached to it — it’s the percentage of the property you own free and clear. If the mortgage has been paid in full, you have 100 percent equity in your home.
However, even with a 100 percent stake, you cannot borrow all of that money. Generally, lenders allow for borrowing up to 80 to 85 percent of a home’s appraised value. That means if your home is worth $500,000 you may be able to access as much as $425,000 of that equity. Or even a bit more — some lenders allow up to 90 or even 95 percent, depending on the type of loan and your creditworthiness. But you never will be able to tap the entire value.
Why should you tap equity on a paid-off house?
Why would anyone pursue fresh financing after finally paying off a mortgage? Well, why not? Your home is an asset, and you can make it work for you. And when you own it free and clear, its tappable potential is at its greatest (see Pros, below).
Viable reasons abound for borrowing against your ownership stake, including:
While these are some of the most common reasons for tapping your equity, you can use the funds however you’d like. According to Bankrate’s Home Equity Insights Survey, 30 percent of millennial homeowners approve of tapping home equity to make investments. In fact, a small percentage of homeowners said they’d even consider taking a vacation or buying big-ticket consumer items as good reasons to swap equity for cash, the survey found.
However, since your home will serve as the collateral for the debt, you should be judicious in how you tap it. Two good rules to follow: Use your equity in ways that improve your finances or work as an investment and don’t take out more than you can afford to lose.
How to get equity out of a house you own outright
Cash-out refinance on a paid-off home
Let’s say you were still paying off your mortgage, had adequate equity and needed cash. You’d likely do a cash-out refinance, which typically has a relatively lower interest rate compared to other types of loans.
You can do the same now, even though you’ve paid off your mortgage. You’ll simply take out a new mortgage and pocket the equity in the form of cash at closing. As with any refinance, however, you’ll be on the hook for closing costs, which can run 2 percent to 5 percent of the amount you’re borrowing and any escrow payments.
Home equity loan on a paid-off home
Alternatively, you could apply for a house-paid-off home equity loan.
Like a cash-out refinance, a home equity loan is secured by your property (the collateral for the loan) and enables you to extract a large amount of equity because you have no other debt attached to the residence. You’ll also likely need to pay closing costs, and as with any mortgage, you risk losing your home if you can’t pay it back.
The upsides: Home equity loans typically come with fixed interest rates, which are usually much lower than personal loan rates. Plus, if you use the money on home improvements, you can deduct the interest on your taxes.
HELOC on a paid-off home
Many homeowners like the flexibility of a home equity line of credit (HELOC), which works like a giant credit card.
HELOCs, which have adjustable interest rates, let you take out money during an initial draw period (which usually lasts 10 years). During that time, you’ll only need to repay the interest on what you’ve borrowed. After the draw period, you’ll enter the repayment period, which gives you 10 to 20 years to pay back the principal and any remaining interest.
What’s more, you’re only responsible for repaying the amount you use versus the fixed obligation of a cash-out refinance or home equity loan, says Vikram Gupta, former head of home equity for PNC Bank.
Do read the fine print of your agreement, though. “Additionally, some HELOCs may have various fees associated with them such as annual fees, early closure fees, and origination fees, so borrowers should pay close attention to these when evaluating their total financing costs,” says Gupta.
On the downside: HELOCs aren’t as easily attainable — you need a strong credit score — and, given their fluctuating interest rates, can mean variable monthly repayments.
Reverse mortgage on a paid-off home
If you’re 62 or older, you could be eligible for a reverse mortgage. This financing vehicle gets you regular payments from a mortgage lender in exchange for your home’s equity.
“A reverse mortgage can be a great way for seniors to access the equity in their homes to pay for monthly living expenses and keep them living independently, especially if they don’t have monthly income in retirement,” says Brown.
Reverse mortgages have pros and cons, though. You’ll still need to keep up with homeowners insurance, property tax and HOA dues payments to avoid foreclosure, and there’s a limit to how much money you can get. You can’t let the home fall into disrepair either — you’ll still be responsible for maintenance.
Most of all: “It’s important for the borrower’s survivors to understand that the entire [reverse mortgage] balance, plus interest and fees, is due if the borrower passes away,” says Gupta. “The borrower’s house may need to be sold if their estate cannot repay the reverse mortgage loan.”
Shared equity agreement on a paid-off home
With a shared equity agreement — a relatively new method of liquidating equity — you’ll sell a portion of your future home equity in exchange for a one-time cash payment.
“The details on how this works and what it costs will vary from investor to investor,” says Andrew Latham, CFP, and content director for SuperMoney.com. “Let’s say you have a property worth $600,000 with $200,000 in equity built up. A home equity investor might offer you $100,000 for a 25 percent share in the appreciation of your home.”
If your home’s value increases to $1 million after 10 years — the typical term for a home equity investment — you’d have to return the $100,000 investment plus 25 percent of the appreciation, which in this case would be $100,000. You’d also need to return the investment plus the share of appreciation if you sell the home.
“The advantage here is that you can access your home’s equity with no monthly payments required, making it an excellent option for homeowners who want to tap into their home’s value but don’t have the cash flow to qualify for traditional home equity financing products,” says Latham.
In effect, you’ll have a silent partner in your home, so you’ll need to be comfortable with that and the rights that partner has to protect their investment.
Pros of tapping equity on a paid-off house
Easier to get approved
On the plus side, it can be relatively easy to qualify for a home equity loan on a paid-off house since you already have a solid track record of paying off your first mortgage, which likely means you’re older and have good credit and possibly a higher income. This ups your creditworthiness as a borrower, making you a preferred candidate to lenders and lowering the interest rate you’ll pay.
You also won’t have to worry about the size of your ownership stake — another criterion that lenders look at, which affects how much you’re able to borrow. Plus, once you’ve paid off your first mortgage, odds are your debt-to-income (DTI) ratio will drastically drop, which strengthens your financial profile.
More money to tap
In evaluating you for home equity financing, lenders will consider all of your home-based debt — including your outstanding primary mortgage and the size of the new loan. Together, these two things can’t exceed a certain loan-to-value ratio or LTV (the size of the debt divided by your home’s worth) the financial institution sets. Let’s say that your lender sets an LTV of 80 percent, and you’ve a mortgage whose balance is 40 percent of your home’s market value. The amount left to borrow can then only be 40 percent of your home’s value – no matter how big the size of your equity stake.
Obviously, the less current debt you have, the more you can borrow against your equity. So, if you still have a sizable chunk of your mortgage to repay, you’ll be more limited in how much equity you can tap. But if you’ve already paid off your first mortgage, you’ll have access to more money – virtually all of your home’s value, in fact, aside from the amount the lender requires you to keep untouched, as a cushion.
No-strings money
Furthermore, you can use your equity for any reason. Most lenders won’t care, for instance, if the money will be put toward funding retirement, seeding a new business or making a down payment on an investment property.
“Many seek to pay for their children’s educational expenses, fund their retirement or pay for an unexpected medical emergency like cancer care for a loved one,” says Kelly McCann, an attorney specializing in construction and real estate with Burnside Law Group in Portland, Ore.
Tax advantages
In addition to being able to use the money for nearly any purpose and being more likely to qualify, tapping into your home equity also offers potential tax advantages.
For one, when you use a home equity loan or HELOC to “buy, build or substantially improve” the home that secures the loan, you can deduct the interest from your taxes. This is known as the mortgage interest deduction.
Another possible tax benefit of accessing your equity? If you use the funds to fix up your home, it could reduce your capital gains liability.
“It may be smarter to tap into your equity than selling your home and downsizing,” says McCann. “If you have capital gains on your home of more than $250,000 (or more than $500,000 if you are a married couple) you must pay taxes on that gain after the sale of your home. However, if you borrow against your home by, for example, taking out a home equity loan, you don’t have to pay taxes on the loan proceeds — you get the money tax-free.”
Cons of tapping equity on a paid-off house
Risk of losing your home
Of course, if you choose a form of financing wherein your home is used as collateral, like a cash-out refinance or home equity loan, there’s always the risk that you could lose your home if you can’t repay.
Upfront expenses
While they often carry lower interest rates than unsecured loans, home equity products aren’t free. Most have upfront expenses and many of those good old closing costs that you remember all-too-well from your first mortgage. You’ll have to come up with the funds to pay for expenses like origination fees and a home appraisal, to name a few. The whole process could be paperwork-heavy and time-consuming, too.
Being frivolous with funds
You’ve got a tempting chunk of change there in your home. But you’ve worked long and hard to acquire this asset, so don’t blow it on one-time, discretionary expenses. Buying a car (a depreciating asset), paying for a wedding or taking a vacation — these are not-so-good reasons to deplete your equity stake.
Diluting asset
When you borrow against your home, you’re essentially turning an asset into a liability. By doing so, you’ll dilute your ownership stake and decrease your overall net worth. Plus, no longer will you be free and clear on your home. Instead, you’ll add more debt (and a new monthly payment) to your plate.
Bottom line on getting equity out of a paid-off home
If you own your home outright, it actually makes it easier to tap your equity stake. Odds are, you’ll come across as a more creditworthy candidate to a lender.
However, determining whether it makes sense to pull equity out of a house you’ve already paid off really comes down to your unique circumstances and financial picture, as well as your short- and long-term goals. It’s also important to consider whether you’d be able to make the payments on the loan if your financial circumstances were to change unexpectedly.
“Homeowners should ask themselves: ‘What is the purpose of the funds needed?’ They also need to assess their individual financial situations to ensure they have the cash flow to pay off the loan in the future, particularly as they approach retirement,” says Gupta.
If you decide to proceed, make sure to practice the due diligence you would apply to any other financial transaction—shop around with several lenders and find the best terms for your needs.
FAQs
Additional reporting by Taylor Freitas
Read the full article here
