If you’re a homeowner who has paid off the mortgage after toiling for years to make payments on time, there’s good reason to celebrate: Your home is finally yours. Another reason to celebrate is that your paid-off home can help make you a more attractive candidate for a home equity loan. You can take out various types of loans including a home equity loan, a home equity line of credit (or HELOC), a reverse mortgage if you’re age 62 or older, a cash-out refinance or a shared equity agreement.
Here’s what you need to know to decide which home equity option makes the most financial sense for you if you’ve already paid off your mortgage.
How to get equity out of a home that’s paid off
The options you have for borrowing against a home that’s paid off are the same as when you were still making monthly mortgage payments. And the reasons to borrow against your fully owned home are also the same: Home equity loans should be used to help finance large home improvement projects, not for nonessential, short-term expenses such as funding a vacation.
“Tapping home equity should be reserved for major, one-time expenses, such as large renovations or repairs like a new roof,” says Greg McBride, chief financial analyst at Bankrate, CNET’s sister site. He says that whether or not your home is paid off, tapping home equity isn’t free money, and it’s not the same as going to an ATM and withdrawing money from your bank account. “This is borrowing, which must be repaid with interest, and it puts your single largest asset on the line in the event of default,” McBride says. “That doesn’t make it a bad option, just one to go into with both eyes open.”
What these home loan options mean is that you’ll have to make monthly mortgage payments again, so be sure your budget can accommodate the added cost.
Using a home equity loan
A home equity loan also gives you a lump sum of cash at a fixed interest rate, but it doesn’t replace your mortgage like a refinance. Instead, it’s an entirely new loan that you’d normally repay monthly, along with your existing mortgage payment. If you’ve already paid off your home, the only monthly payment you’ll have to make is on your new home equity loan. The benefit is that your interest rate won’t go up and your monthly payments are fixed, too.
Using a HELOC
A HELOC, is a loan that lets you borrow against your home equity and functions like a credit card. It provides you with an open line of credit that you can access for a certain amount of time, typically 10 years, followed by a set repayment period, which is usually 20 years. The upside of a HELOC is that you don’t have to take all of your funds out at once; you can withdraw money repeatedly from your HELOC over the 10-year period. If you’ve paid off your home and you need funds for an ongoing expense, such as a major home renovation or college tuition, this could be a good option to consider.
Using a reverse mortgage
To access a reverse mortgage, you must be age 62 or older and have either paid off your home or have a significant amount of equity accumulated (generally at least 50%). With a reverse mortgage, the major benefit is that you don’t have to make monthly mortgage payments -- the bank or lender actually makes payments to you. This is a good option for homeowners who may not be able to afford adding a new monthly mortgage payment to their budget, but who need help covering routine expenses as they transition to retirement.
“A reverse mortgage allows you to access home equity in the form of a lump sum, line of credit or series of regular payments without adding another monthly expense to your budget, as it doesn’t have to be repaid until you sell your home, or permanently move out of it,” says McBride.
To qualify, you must still pay your property taxes and homeowners insurance and continue to live in the home. It’s important to keep in mind that you’re building a mortgage balance back up as you borrow against your equity, and your estate will eventually have to pay off your loan. A typical way to repay this loan to the bank is to sell your home.
Using a cash-out refinance
A cash-out refinance gives you a lump sum of cash at a fixed-interest rate. It replaces your current mortgage with an entirely new one that has more attractive terms, typically a lower interest rate. Usually, the money you borrow against your home equity is added back on the balance of your mortgage and you pay it off as one monthly payment. If you’ve already paid off your home, you’ll get a new mortgage, which you’ll need to start paying off again. Mortgage rates are at their highest levels in 20 years, so a cash-out refi isn’t the most beneficial option right now.
Entering into a shared equity agreement
This is a more complicated arrangement that may not make sense to the average homeowner. Think of this option in terms of a start-up company: The founder of the company gives away some of the equity in their business in order to receive cash from investors to pay for daily expenses. When you enter a shared equity agreement for your home, you’ll be working with an investment company and giving a percentage of your home to that investor in exchange for upfront funds.
The major benefit of a shared equity agreement is that you don’t have to take out any debt or make monthly payments to pay back the loan, but you’re on the hook for buying out your investing partner for their share of your equity in the future value of your home. You’ll have to pay back the initial loan amount, as well as an additional percentage of either your home’s appreciation or its appraised value at the time of repayment, depending on your specific agreement.
Pros and cons of taking equity out of a home that’s paid off
Pros
Easy to qualify: You shouldn’t have a hard time being approved for a home equity loan with a paid-off mortgage as you’ve demonstrated that you can pay back your loan responsibly.
You don’t have to sell your home: You can continue to live in your home without having to move or sell your largest asset while still gaining access to funds at a relatively low interest rate.
No monthly payments: Although it doesn’t apply across the board, some types of home equity loans, such as reverse mortgages and shared equity agreements, actually pay you and don’t require you to make monthly payments as part of your repayment schedule.
Cons
You’re using your home as collateral: Your property secures the loan, which means your lender can repossess your home if you fail to make payments.
Extra fees and closing costs: With most home equity loans you’ll have to pay anywhere from 2% to 5% of the total loan amount in closing costs, which adds thousands of dollars to your balance.
Less upside when you sell: If you take equity of your home, you will receive less from the sale than when you paid off your home entirely.
Why would you want to mortgage the home you fully own?
You should use a home equity loan for projects that add long-term value to your home, and your life, not merely for one-time expenses such as a vacation. Projects such as home repairs, funding for retirement or funding for a child’s college tuition are investments in your future that may be worthy of borrowing against your home, compared with something as fleeting as a two-week vacation.
If you’re taking on a large endeavor such as starting a business, a home equity loan will usually have lower interest rates than a personal loan and credit cards, saving you thousands of dollars over the time you pay it. Whether you should borrow against your home depends on the specific type of expense and whether it will provide long-term value.
The bottom line
If you’ve paid off your home in full, you can still take out a home equity loan against your property. It means you’ll have a monthly mortgage payment again, so make sure you can afford the additional cost. When taking out a home equity loan, consider the interest rate, additional lender costs and fees, as well as the size of the loan and how it’ll be disbursed to you. Taking out a home equity loan is essentially the same process as it was when you were paying off your mortgage. The type of loan that’s best for you will depend on your personal financial situation.
