In July 2020, Black Knight, a Jacksonville-based provider of integrated software, information and data insights (across the many phases of the homeownership life cycle), released its Mortgage Monitor Data Report for 2020 – Quarter 1.

The monitor report extracts information from Black Knight’s industry performance plus a host of relevant public (i.e., governmental) and housing datasets (often generated from private metric firms) available for this specific block of time. Black Knight’s report offers some profound insights into the current state of the American real estate market, as noted, in part, below.

  • The amount of available equity during the first quarter of 2020 had reached a historic high of $6.5 trillion – an upward trend of 8% on an annual basis.
  • Because mortgage interest rates have continued to fall to historic lows throughout 2020, Black Knight has calculated that about 90% of property owners, who meet current underwriting standards, now have available equity in their homes that remains untapped.

This is important – homeowners with tappable equity are currently paying interest rates on their current first-lien mortgages that are higher (sometimes significantly) than current market conditions of similar mortgage products!

In fact, Black Knight’s analysis deduces that millions of mortgagors who would meet current underwriting standards now – at their disposal – can reduce about ¾ of one percentage point off their current rate by merely refinancing. Black Knight’s statistical analysis extrapolates current data to conclude that nearly 14 million homeowners eligible for refinancing today would likely save – on average – $283 per month – or as an aggregate – $3.9 billion per month.

How helpful would a $4 billion injection (of virtually found money) into the economy be at this time?

But despite all of this historic untapped equity, Black Knight’s statistics note that ‘cash-out refinances’ amounted to only about 42% of all refinance applications during 2020-Q1 – about half the amount noted in 2018-Q4 – the recent high.

This dip in mortgages that were ear-marked as cash-out refinances at first glance appears puzzling when one considers that in 2020 – Q1, there were a record number of refinancing applications overall, and money is cheap right now.

However, borrowing money is never done in a vacuum, so it might help to learn that there are rising concerns about the increasing rates of mortgage delinquencies during this time. After all, unemployment continues to plague the economic recovery like a cold March wind refusing to allow spring to arrive.

So, for those homeowners who are in a position to take advantage of historic levels of untapped equity at historically low-interest rates – Carpe Diem! But seize the day prudently before these historically low interest rates are only visible in your rearview mirror.

Untapped Equity Is Dead Money – Unless it is Put to Work for You!

Independent of the inevitable appreciation of most real estate, the equity that remains untapped in real estate essentially offers its owners/investors an absolutely ZERO rate of return – in some cases paying less than the paltry savings average rates for cash invested in FDIC-insured products.

Untapped equity is deemed ‘dead money’ because it does not offer the generation of income. An example, albeit oversimplified, will illustrate and clarify this important point –

Bob, a successful real estate investor, owns five real estate properties – free and clear – with a value of $100,000 for each property. As such, Bob owns real estate properties that total a value of $500,000 (= 5 * $100,000). Each of Bob’s properties is rented with a positive cash flow (after deducting for the property’s operational costs/expenses) of $1,000 per month – providing Bob with a monthly cash flow after expenses of $5,000.

After speaking with some sage financial advisors, Bob decides to refinance these investment properties and pull out half the available equity – $250,000. He chooses to purchase five additional similar investment properties as follows –

Each property costs $100K, and Bob chooses to carry a $50,000 mortgage (putting $50K as a down payment on each property) at 4% mortgage on each property. These additional investment properties will generate similar revenues to the original five investment properties. However, the net profit will be a bit less due to the need to carry the cost of the new mortgage debt required to purchase the units.

After the refinancing is complete, Bob’s net income for each of his rental properties was reduced to $700 month for each unit; however, overall, Bob’s net income increases to $7,000 per month. Let’s review Bob’s investment portfolio and income before and after his choice to start using existing untapped equity in his existing real estate holdings.

Bob’s Real Estate Investment Holdings
  Initial Real Estate Holdings Updated Real Estate Holdings
# of Properties 5 Rental Properties 10 Rental Properties
Value of Real Estate $ 500,000 $ 1,000,000
Monthly Net Income $5,000 = $1000/each (5) $7,000 = $700/each (10)
Yearly Net Income $60,000 $84,000

In conclusion, by choosing to proactively use the existing equity (remember, Bob only used half the existing equity) within his real estate, Bob was able to increase his monthly income by 40% – $7,000 – $5,000 = $2,000; then $2,000/$5,000 = .4 or 40%.

Because the above example has been simplified for illustration purposes, there was no way to account for the fact that Bob will now be on the receiving end of the appreciation of twice as many properties, plus the 40% increase in his income.

Please note that while Bob’s investment property example has been oversimplified, it still powerfully demonstrates how an investor’s use of equity can greatly improve one’s net income or bottom line.

Converting Equity to Cash for Investment Purpose

So, if you have an interest – and the equity in a property that you would like to convert to cash and ultimately create an ongoing cash flow – here are a few of the most popular techniques of extracting equity from one’s real estate holdings. Note, first, however, that the rules for taking cash out of a property will vary – depending mostly on the use of the property –

  • Is the subject property a primary residence?
  • Is the subject property a single-family or multi-family residence?
  • Is the subject property an investment or rental property?
  • Is the subject property a second home?

Depending on how a borrower answers any of the above questions will dictate the underwriting guidelines that will determine the maximum amount of cash-out equity that may be taken by a property owner.

The Cash-Out Refinance

Borrowers often choose to refinance their mortgage for three primary reasons:

  • To lower their monthly payment by lowering the rate.
  • To reduce the number of years, it takes to pay off their mortgage by reducing the term (i.e., from 25 to 15 years)
  • To pull equity out of their home and use it to:
    • Invest and create an income stream
    • Consolidate higher-interest debt
    • Pay off college costs.
    • Update or improve the property, among others.

A cash-out refinance, at least during this unusual moment in history, is often the preferred choice because interest rates are typically lower today than in the past for most homeowners. However, there are financial scenarios where it does not make financial sense to refinance a mortgage, and when that occurs, borrowers turn to these options –

The Home Equity Loan

A Home Equity loan resembles a traditional mortgage when approved. The borrower receives a lump sum amount minus the costs to close the mortgage if any. Home equity loans begin to accrue interest at closing, with the highest interest amounts due at the start of the mortgage loan.

A Home Equity loan requires homeowners to pay monthly installments throughout the term, which can range between five years to up to 30 years – with the average home equity loan offered at 10 to 15 years. Home equity loans are collateralized, which generally results in more advantageous rates than credit cards, personal loans, or any other unsecured debt.

The Pros of the Home Equity Loan

The advantages of home equity loans include the following:

  • Lower Rates and, therefore, lower payments.
  • Large Loan Amounts are usually available for home equity loans.
  • Potential Tax Benefits – when collateralized by real estate, interest payments may be deductible – please check with your tax advisor.
  • Allows for flexibility as to its use, unless determined by the mortgage underwriter.

The Cons of the Home Equity Loan

The disadvantages of home equity loans include the following:

  • The property can be lost in a foreclosure sale for nonpayment by offering one’s home as collateral.
  • A home equity loan is likely to cost more to close than a personal or unsecured loan, although the cost to close can be funded through the home equity’s proceeds.
  • Extracting excessive equity may leave a homeowner underwater, with mortgages that exceed the home’s value. This situation makes it amazingly challenging to sell a property without the lender’s cooperation.

The Home Equity Line Of Credit (HELOC)

A HELOC or, as it is better known – a Home Equity Line of Credit allows property owners to access their equity but does so using a financial instrument that more resembles how a credit card performs. A Home Equity Line of Credit permits borrowers to repay and then re-borrow money (up to the line of credit’s limit) secured by the collateralized property.

Interest does NOT start accruing on the line’s credit until the homeowner actually uses the monies from the secured line of credit. As such, one can close on a HELOC and not use the available funds until a future date – without any interest earned by the lender until such time the borrower uses the money.  Many people choose to keep a HELOC open on a property as it acts as a prudent emergency fund. A HELOC is most often provided with adjustable rates, although some lenders offer fixed products to customers who qualify.

HELOCs have a unique structure:

  • There is an access period in which funds are available to be used and re-used. Lenders typically allow borrowers to only pay interest (at a minimum) during this time, which typically runs for ten years.
  • When the access period is closed, the repayment period begins. And while a borrower can no longer access any unused funds, they are usually given 5 – 20 years to repay the existing balance. Note, though, some HELOCs conclude with balloon payments (large lump-sum payments due at once), which should have been disclosed to the borrowers at closing.

The Pros of the Home Equity Line of Credit

The advantages of a home equity line of credit include the following –

  • Lower Rates and therefore, lower payments.
  • Interest accrues on only the outstanding balance, not the total credit line maximum.
  • Large Loan Amounts are usually available for home equity lines – some max out as high as $1,000,000+, from certain lenders.
  • Potential Tax Benefits – when collateralized by real estate, interest payments may be deductible – please check with your tax advisor.
  • Allows for flexibility as to its use, unless determined by the mortgage underwriter.

The Cons of the Home Equity Line of Credit

The disadvantages of a home equity line of credit include similar risks to those noted above for home equity loans.

Wrapping Up

Choosing to tap into existing equity can be a smart financial decision when the equity is used to create additional cash flows and income for its owners.  However, not every HELOC or home equity loan is created equal, which requires homeowners and investors to remain diligent when investigating potential mortgage options before diving headfirst into a regretful situation.