Home equity loans and lines of credit can be used to pay for home improvements, consolidating consumer debt or financing a major purchase like a vehicle. Choosing a loan requires an understanding how home equity loans and lines of credit work. Which product is better, the line of credit or the loan? That depends on the purpose of the loan and whether the proceeds will pay for a one-time expense (like debt consolidation) or a series of ongoing costs (like semi-annual college tuition).
How Much? Home Equity Loans and Combined Loan-to-Value (CLTV)
Home equity loans are mortgages that are subordinate to a primary home loan. In fact, they are often called "second mortgages." The amount of a home loan divided by the property value equals a ratio called the loan-to-value, or LTV. If Mr. Jones owns property worth $200,000 with a $100,000 first mortgage, his LTV is 50 percent.
The total amount of loans (first and second mortgages) divided by the property value equals the combined loan-to-value, or CLTV. For example, if Mr. Jones also has a $20,000 home equity loan, his CLTV = 120,000/200,000. That's 60 percent.
In general, mortgage lenders prefer to keep CLTV at 90 percent or lower, and some won't lend above 80 percent.
Home Equity Loans for Lump Sums
Terms of home equity loans are similar to those of primary mortgages. A home equity loan delivers a lump sum at closing, which is repaid over time with monthly payments. Home equity loans usually have fixed interest rates, but they can also have variable interest rates. It is important to know whether a home equity loan has a fixed or adjustable interest rate, as interest rate adjustments change the monthly payment and may increase its cost. A home equity loan is a good choice for zeroing out bills, paying for a medical emergency or making one-time home improvements. According to the Consumer Financial Protection Bureau, costs associated with home equity loans typically include discount points and additional charges not applicable to home equity lines of credit.
Home Equity Line of Credit for Flexibility
Home equity lines of credit, sometimes called HELOCs, are revolving accounts secured by home equity. HELOCs provide convenient access to cash (they often come with a check book or card). Each draw against a home equity line of credit increases mortgage debt and decreases home equity. HELOCs generally feature a "draw period" of up to ten years in which the borrower can tap the line as needed. Once this period expires, the homeowner no longer has access to the line and uses the remaining term to pay off the balance. When shopping for a HELOC, understanding its draw period (how long funds may be drawn against the line of credit) and the length of the repayment period is significant.
Homeowners choosing a loan or home equity line of credit find the flexibility of a HELOC useful in situations that require more than one payment over time. Examples include major home renovations where contractors are paid as the job moves along, education costs that reoccur each semester or quarter, and or just having a source of back-up funds for your small business. A HELOC requires payment only for amounts borrowed, and interest is not charged until an withdrawal is made against the line of credit.
Choosing a loan or line of credit with these considerations in mind is the first step. The next step is to compare several quotes for a home equity loan or line of credit. Costs and loan terms can vary and line-by-line review and comparison is the best way for homeowners to find the best deal on home equity financing.