Homeowners are sitting on record equity, so here’s how to cash out when mortgage rates are rising

American homeowners are house rich, sitting on a record amount of home equity.

Taking advantage of all that extra cash, however, becomes more difficult as interest rates rise.

Soaring housing demand over the past year and a half, driven in large part by the pandemic, caused home prices to spike. There simply wasn’t enough supply to meet the demand. Prices have now climbed close to 20% from a year ago.

As a result, homeowners gained a massive amount of tappable equity — the sum borrowers can generally take out of their homes while still leaving at least 20% as a cushion. By the end of the third quarter, borrowers had a record $9.4 trillion in tappable home equity collectively, or an average of $178,000 per borrower, according to Black Knight, a mortgage data and analytics firm.

That marks a 32% jump year-over-year.

As the available cash climbed, borrowers took equity out of their homes during the third quarter at the highest rate in 14 years. It was relatively inexpensive for them because mortgage rates were low at the time, with the average rate on the 30-year fixed under 3%, according to Mortgage News Daily.

Now rates have ticked above 3% and are expected to rise further as the Federal Reserve slows its purchases of mortgage-backed bonds. As rates rise, a cash-out refinance becomes less attractive because a lot of borrowers would have to refinance to a higher rate than they currently have.

As of now, 24% of all first lien mortgages have an interest rate below 3%, according to Black Knight.

Borrowers could take out a home equity line of credit, which is a second lien, but those generally have variable interest rates, meaning they can move higher or lower. Some lenders will offer shorter fixed terms, but all home equity lines have a draw period and a repayment period.

So borrowers can draw on that line of credit for, say, 10 years, but then after that period they have to start paying the money back. They do have to pay interest on the money they take out during the draw period.

Moving from the draw period to the repayment period can be a shock to borrowers’ wallet as well, since they have to pay both interest and principal.

“You have to take the whole picture into consideration — current debt amount and associated interest rates, how much you’re looking to borrow, available HELOC vs. cash-out rate offerings, timeline for paying off the additional debt, and so on,” said Andy Walden, vice president of market research at Black Knight. “To make the best decision, homeowners need to run the numbers both ways and see what makes the most sense for their particular case.”

Sometimes it does make sense for borrowers to do a cash-out refinance of their primary mortgage, even if the rate they get is higher than the rate they currently have.

“If homeowners are looking for a defined structure to pay off their debt, such as credit cards, it often makes financial sense to take a slightly higher interest rate through a cash-out refinance to consolidate and immediately eliminate the interest which is often four-to-five times as high,” said Matthew Weaver, vice president at CrossCountry Mortgage.

Taking cash out of the home to invest in something else with a higher return could also boost the case for taking a slightly higher interest rate. Borrowers should look at the potential risks and returns on that investment, whether it is stocks, cryptocurrency, or even an investment home, and weigh it against the extra cost of the debt.

“I would recommend a line of credit when the financial need is short term and there is a defined plan in place to pay it off over the next 24 to 36 months,” Weaver added. “The advantage of the line of credit is that it is flexible with low upfront cost, however the disadvantage is that most carry a variable interest rate that will change and likely increase over time.”

Borrowers have been extremely cautious in taking cash out of their homes since the financial crisis of 2007-2008. Home prices fell so far that a huge swath of borrowers dipped underwater on their homes loans, owing more than the properties were worth.

That is unlikely to happen today, as mortgage underwriting is much more strict and borrowers have a lot of home equity.

Home prices are expected to rise next year as well, but the gain should be smaller than they were this year as more homes come on the market and interest rates rise. Borrowers should be able to take cash out of their homes safely now, but the larger the equity cushion they leave in the home, the less risk they take on.