If you're looking at using your home's equity, that means that you own a house right now. You've probably been in there for a period of time and you've built up some equity in the property that you're living in. So maybe you purchased that property a couple of years ago as your home is gaining appreciation and you're paying down your mortgage. That gap is where you get equity?
Equity just means how much value do you have to build up in your home? If you were to sell the house right now, how much cash could you take out of that house? That's what equity is. We can tap into that equity to be able to purchase a second property, whether that's a primary residence or an investment property with that equity. You could also buy other things. You could also pay off debt or pay down, college loans or use that to go on a vacation. I wouldn't recommend it, but something that you could do.
So you probably are running into two scenarios. You are either buying a new primary residence. So this might mean you're in a home right now and you're wanting to purchase another house to move into. This is often what's called a stepping stone approach or a move-up purchase.
Most of the time, what happens is somebody is going to buy a home. Initially, they're going to build up equity, and then they'll use that equity as a down payment, on a larger home or in a home that it's in a better school district or a nicer, more desirable neighborhood or, maybe you're downsizing and you're taking out some cash. That's another option as well. But most of the time people are taking the money that they have in their house right now that value and transferring it over into another property.
Another option is you're living in the home that you're in right now, but you want to take out some equity to buy an investment property. Now, this is a really great solution because what you're doing is taking the money that's already working for you. It's building appreciation and you're paying down your mortgage. So you're getting equity there, but you're taking that equity and then moving it over into another property. That way you can build an appreciation on that property as well, and most likely, you're either going to flip that property. To fix it up and sell it for more money, or you're going to have tenants who are paying you some rent to pay down that mortgage for you.
So that's another option as well. Both of these are very common. Really just depends on how you're wanting to use the equity in your house to purchase a second property.
Most people don't realize that they can use the equity in their house to buy an investment property. So it's a great option. So let's talk through, some different options of what types of loans you might be using to get this money.
So there are three main ways that you can pull the equity out of your house. The reason that we have to use these different methods is that you can't just go to a bank or your mortgage company and ask for that money because technically this money doesn't exist. It's more closely similar to something that's called unrealized gain. So that might, isn't actually existing anywhere.
It's more of just the potential money that is there, the potential value that you have in your home. Since it's stored in the asset of your house, it doesn't actually exist anywhere except more in theory. So it can get a little weird, but we have to use tools to pull that equity out of the home that we're in right now.
So the first tool that we can use is just to sell the property. So when you sell the property, this is where you're just getting. Straight-up cash from the sale of your property. So let's say it's a $200,000 house. You only owe, let's say a hundred thousand dollars left on your mortgage. That means you have a hundred thousand dollars in cash that you'll get when you sell the property. And this is going to come probably in a wire transfer or a check, and that's straight cash that you get to use. So selling is one option, it's not the most common. Those are the other two strategies right there. These are going to be debt-focused strategies. So selling strategies, not debt focused, it's going to be entirely cash.
So let's talk about HELOC. HELOC stands for Home Equity Line of Credit, and we take that phrase and we chunk it all together and call it a HELOC. And a HELOC is a line of credit. So think of HELOC almost like a credit card of sorts against your home. That's like a secured credit card against your home basically.
It's a line of credit, meaning that you're going to get approved for a certain amount, but you don't have to use it all immediately. And if you don't use it, you don't have to pay any interest on it. So let's say that you got a HELOC for $30,000. So that means it's secured against your home. So to put what's called a second lien on your property. So when you do go sell the house in the future, that's going to be paid off, from your proceeds. But a HELOC is going to work. Let's say we had that $30,000, you might have some projects and you want to go spend, $5,000.
So now you have $25,000 remaining. You don't have to pay any interest or anything on that 25,000. You're only paying the interest on the 5,000 that you pulled out, you got approved up to a limit, but you only had to use a certain amount. So in that way, it's almost like a credit card. It doesn't work exactly like it, but with the HELOC, some considerations that you have sometimes they're going to be interest-only for a certain period, which is really great for short-term projects.
I think HELOC her great for more short-term things, that you're looking at or looking to pay those downs quicker. So normally with a HELOC, you're going to want to pay that down quicker, just because those terms can be a little bit more costly over a period of time. So you're going to have interest-only payments, which can be good to lower your payment, but you're not paying anything towards the principal, which can be dangerous because it's just going to keep going on until you pay down the principal.
Also, this HELOC not only is going to be interested only, but you're going to have a floating rate sometimes. So this is what's called an adjustable rate. That means that that rate isn't going to be fixed. Sometimes it can be fluctuating. It depends on, how your HELOC is set up, but something to be mindful of, you don't want to carry this big balance on there that you haven't paid down now you're making interest-only payments, and then all of a sudden your rate gets a lot higher because the market shifts. So something to be aware of, HELOCs are greater for short-term uses.
Cash out is kind of a blend of the two. This is where you're going to take money from your house. You're going to increase your mortgage. So you'll increase your mortgage and that's going to give you cash. So when you close on a cash out refinance, you refinance your first mortgage, you increase it and then you take that, whatever that increase was, and you get a lump sum of cash at the closing table.
So in a cash out, let's say that your first mortgage is for a hundred thousand dollars. Let's say you want to pull out $30,000 in cash from your current home. So what you would then do is you would refinance your loan to be an additional $30,000, and then this money would come to you as cash. So you're basically taking out a loan and tying it in with your first mortgage. It's a full refinance that lets you pull cash out.
Cash outs are going to be better for long-term uses of that money and making sure that you have a strategy to pay that back over a long period of time since it's built into your first mortgage. It's also easier to manage because you're only getting one mortgage payment from a cash out if you're doing a HELOC, not only are you paying your first mortgage, but you also have to pay the HELOC on top of that as well.
Now let's talk about how you actually calculate. So when you have this money in your house, you have this equity, you need to figure out first, how much equity do you have and how much are you allowed to pull out of your home right now. Because lenders have limits on how much risk they're willing to, give you to be able to pull this money out.
So let's act like we're purchasing, whenever you're purchasing a home and you're putting a down payment down on the house. And the reason why is because that makes the loan less risky. If you're getting a loan for the entire value of the house. Then that becomes really risky to lenders in case the market changes and fluctuates. They want to make sure that you have money to be able to pay them back, or if they foreclosed that they can get their money back. The same thing applies to any type of HELOC or a cash-out refinance.
They're going to have limits, what's called a combined loan to value ratio. This is the limit basically of how much value you have in your home versus the max amount of debt that you have against that property. So let's say your combined loan to value limit is, uh, 90%, right? So it's, it's normally going to be anywhere between 80 and 90%.
In between 80 and 90% as you could pull out, in a mortgage on your current property. So let's say you had a $100,000 house, then you might be able to have a max mortgage of 80 to 90,000. So we have to count in the first mortgage plus any HELOC or if we're adding anything on that cash-out refinance as a max.
So on a hundred thousand dollar house, the max we could have as a mortgage would be 80,000 or 90,000. So basically what you're going to do is you're going to take the value of your property, times the combined loan to value ratio, and then subtract your current balance. And that's going to show you how much left you have to be able to pull it out of your home.
So let's run through an example. Let's say that your home is worth $300,000, you talk to your bank and they're saying the max that you can do on let's say a cash-out refinance is 80%. So then what we'll do is we will go ahead and we'll take 300,000 times 0.8. That's going to give us $240,000.
And then let's say we have a remaining balance on our mortgage of, let's say $150,000. So we take the $240,000 minus $150,000. And that gives us $90,000. So $90,000 is the most that we might be able to pull in that cash out or a home equity line of credit, to be able to maybe invest in another, or we can take that, and put it on a down payment for a new house.
Something to keep in mind is when you are looking at buying a new house and looking at managing those at the same time is you need to look at, do you have to qualify for both of those mortgage payments at the same time, you might be able to make a down payment, but you might not be able to qualify with both of those payments.
So just to wrap up, you absolutely can take the equity out of your home and use that to purchase a second property. It might be a home that you're living in, or it might be an investment property. The problem is that money doesn't just exist somewhere in a bank account. We have to use tools to get that equity out of our house.
The way that we do that, as we either sell the house, we use something like a HELOC, or we use a cash out refinance to be able to take that money and then use it the way we want to use it. And there are guidelines on how much money we can pull out. We can't always pull out all the equity.
The only way to take all of the equity out of a house is to sell it. If we're using debt, focus, options like HELOC or cash out, we have a lot more rules that we have to follow. I hope this was helpful in helping you understand equity and what that looks like.
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