You've paid off your mortgage, congratulations! But now you have a massive home repair project and not enough ready cash to cover it. How can you come up with the money? One option is taking out a home equity loan on your paid-off home. Here is what you should know before you go ahead.
- Yes, you can take out a home equity loan on a home with no mortgage.
- Not having a mortgage only increases the amount you can borrow with a home equity loan.
- Borrowing against your home carries risks that you'll want to consider.
- If you’re uncertain how much money you need to borrow, a home equity line of credit (HELOC) might be a better option.
- If the amount you are borrowing is sufficiently large, a cash-out refinance could cost you less in interest and fees than a home equity loan.
How a Home Equity Loan Works When You Have No Mortgage
A home equity loan allows you to borrow against the equity you've accumulated in your home. You receive a one-time lump sum from the lender and immediately start paying it back with fixed monthly payments over an agreed-upon time period, such as 10 or 20 years. Because it is secured by your home, a home equity loan will have a lower interest rate than unsecured debt, such as a credit card or a personal loan. The downside is that your home will be at risk if you can't pay it back.
However, a home equity loan may be somewhat less risky if you aren't also carrying a regular mortgage because you will have less debt overall. You'll also be at less risk of finding yourself underwater—a situation in which falling home prices leave you owing more than your home is worth. Being underwater can make it impossible to sell your home unless you are able to come up with enough money from other sources to fully pay off your loans.
Having a paid-off mortgage also makes it easier for lenders to calculate how much equity you have in your home and how large a loan they might be willing to offer you. Your equity is whatever you could sell the property for today.
Home Equity Loan vs. HELOC When Your Home Is Paid Off
A home equity loan isn't the only way to draw on your equity. Another is a home equity line of credit (HELOC).
With a HELOC, you get a line of credit from the lender that you can draw on as needed, rather than a single lump sum at the outset as is the case with a home equity loan. If you don't actually need money now but want future access to credit at a lower interest rate than a traditional credit card, a HELOC may be a better option for you. One downside is that HELOCs usually have a variable interest rate, so when interest rates are rising, your payments can increase significantly.
If you know the exact amount you need to borrow and aren't comfortable with the uncertainty of a variable interest rate, a home equity loan is probably a better choice for you.
Home Equity Loan vs. Cash-Out Refinance When Your Home Is Paid Off
Yet another option is cash-out refinancing. In a typical cash-out refinance, the homeowner takes out a new mortgage for more money than they owe on their current one. After they've paid off the old mortgage, the extra cash is theirs to spend. They will still have to pay it back, of course, and it will be racking up interest in the meantime.
If your home is paid off, however, you don't have a mortgage to repay, so the full amount of the loan becomes yours to do with as you please.
Deciding between a home equity loan versus a cash-out refinance on a paid-off home is relatively easy. If you know the exact amount of cash you need, get estimates from lenders for both. Then compare their annual percentage rates (APRs).
Plugging your numbers into our mortgage calculator below will show you which option saves you the most money over the life of each loan.
What Are the Lending Requirements for a Home Equity Loan?
A home equity loan has many of the same lending requirements as other loan products—a verifiable income history, a good debt-to-income ratio, and decent credit. In addition to these requirements, you'll need to have a combined loan-to-value (CLTV) ratio of 85% or less in your home. That means the total balance of all the loans on your home divided by the current value of your home is 85% or less. For people without a mortgage, you have a 0% CLTV, which means you definitely meet the CLTV requirement for a home equity loan.
What Are the Alternatives to a Home Equity Loan?
The best alternative to a home equity loan is either a fully funded emergency fund or saving in advance for whatever you're considering taking out a home equity loan for. If that's not possible in your particular situation, a 0% APR credit card or personal loan are two options that don't risk your home if you can't afford to pay them back.
Can You Lose Your Home if You Don’t Pay Back Your Home Equity Loan?
Yes, you can lose your home to foreclosure if you don't pay back your lender and default on the loan.
The Bottom Line
Taking out a home equity loan when you don't have a mortgage is very similar to taking one out when you do have a mortgage. Before you do, however, compare the alternatives, such as a home equity line of credit or cash-out refinance. You'll also want to make sure you understand the risks involved and that you're taking out a home equity loan for sound financial reasons.