Home Equity Loan vs Home Equity Line of Credit
Homeowners who want access to large amounts of cash may be able to borrow against their home equity. This is typically defined as how much of your home you own outright. Home equity is calculated using your home’s current value minus any liens against it, such as your mortgage. For example, if your home is worth $200,000 and you still have $100,000 left on your mortgage, you have $100,000 in home equity.
When thinking about taking a home equity financing loan, it’s important to do your due diligence and research all your options. These types of loans, while similar, can cost you more or less depending on how you plan on using the funds. Understanding your obligations, including how much you’ll end up paying over the duration of your loan will help you make the best choice for your needs.
Even though both types of loans use your home as collateral, HELOCs and home equity loans differ in terms of how you access loan funds and make repayments.
What is a home equity line of credit?
A home equity line of credit, or HELOC, gives borrowers a line of credit in which to draw funds from as needed. Think of a HELOC like using a credit card, where your lender determines a maximum loan amount and you can take out as much money as you need until you reach the limit. You are required to make monthly payments to pay back your loan. Since you may not be borrowing the full amount offered, you’re only making payments on how much you actually take out. Some lenders may have requirements such as minimum withdrawal amounts, an initial advance or keeping a minimum amount of outstanding debt. You may also be offered different ways you can access the cash such as credit cards and checks.
Typically, you have what’s known as a draw period for a HELOC, or a fixed amount of time in which you can withdraw money from your line of credit. Depending on your lender, the draw period can last up to 10 years and you’re only paying back the interest during this time. Once the draw period is over, you can’t borrow any more money. You’ll enter into what is known as the repayment period when you pay back the principal amount (plus any interest) borrowed. This repayment period varies from lender to lender.
Most HELOC loans have variable interest rates. This means that your monthly payments will vary depending on whether rates go up or down. Lenders may offer borrowers an initial lower promotional rate. During the introductory period, your monthly payments will be lower and increase once it’s over. Lenders will use an index like the prime rate, plus what’s known as a “margin” to determine their rates. A margin is the percentage points a lender adds on top of the index rate. Some lenders will also limit how many times interest rates will change throughout the duration of the loan, also called a lifetime cap. There’s also a periodic cap which places a limit.
Who HELOCs are best for: A HELOC loan is best suited for those who want access to a reserve of cash over a certain period of time. They may want the money in smaller increments for things such as a home remodel or medical bills. In other words, these borrowers aren’t sure exactly how much money they’ll need and when.
What is a Home Equity loan?
Like a HELOC, a home equity loan (sometimes referred to as a HELOAN) is also known as a second mortgage because both types of financing may be your second loan against your home, whereas your first one was used toward the purchase of the property. However, a home equity loan gives borrowers a fixed amount of money in one lump sum instead of a revolving line of credit. You pay back the loan over an agreed term.
Most home equity loans have fixed rates, meaning the interest rate doesn’t change for the duration of the loan. You’re also paying down part of the principal alongside interest payments until your loan is fully paid off, also called an amortization. Interest rates for home equity loans tend to be higher than HELOCs because lenders give you the security of a fixed rate.
Who home equity loans are best for: Home equity loans are best for those who know how much they’ll need to borrow, or who prefer getting their loan in one lump sum. You may have a large expense you need to pay for, such as a major home repair, and may not need or plan for any additional loans. It’s also best for those who prefer fixed monthly payments.
Home Equity Line of Credit vs Home Equity Loan
Whichever option you choose, both HELOC and home equity loans do come with closing costs. These may be similar to what you paid when you took out your first mortgage. Closing costs can include a home appraisal, an application fee, title search and attorney’s fees.
You may have to pay additional fees if you’re taking out a HELOC, such as discount points (where one point is the equivalent of 1% of your credit limit), annual membership and maintenance fees or transaction fees each time you withdraw money from your credit line.
|HELOC vs Home Equity|
|Feature (i.e .interest tax-deductible)||✓||✓|
|Withdraw funds as needed||✓|
|Pay interest based on amount withdrawn||✓|
|Uses home as collateral||✓||✓|
How much can you borrow against your equity?
To calculate your home equity, you’ll need to take the current appraised value of your home and subtract how much you still owe, which includes any liens on the home. If you’re not sure how much your home is currently worth, you can use Lending Tree’s Home Value Tool to estimate the value.
For example, your home is currently worth $400,000 and you have a mortgage with a balance of $250,000. The amount after you subtract $250,000 from $400,000 is $150,000. This is how much home equity you have.
You can also calculate home equity using a loan-to-value ratio (LTV). This ratio is expressed as a percentage. You calculate it by take your home’s current value and dividing it by the amount you still owe. If your home is worth $400,000 and you still owe $250,000, your LTV would be 62.5%
As for how much you can borrow against your equity, it depends on the lender. In most cases, lenders will not let you borrow all of your home equity. Lenders will set a limit by taking a percentage of the appraised value of your home and subtracting it from how much you owe on the home. They use the LTV ratio to determine the maximum amount to lend you. If you have more than one loan against your home, lenders will use a combined loan-to-value ratio or CLTV. Most lenders will only let you borrow up to 85% of the current value of your home.
For example, a lender lets you borrow up to a loan-to-value ratio of 85%. Your home is currently valued at $400,000 and you still owe $250,000 on your mortgage. This means you can borrow up to $90,000 in home equity loans:
$400,000 x 85% = $340,000 (loan-to-value ratio)
$340,000 – $250,000 = $90,000 (maximum loan-to-value ratio, minus what you still owe)
Of course, the above calculations are simply a guideline. The actual amount depends on your credit score, income history, and other debts. But the example provided should give you a good estimate as to how much you could borrow.
Benefits of financing using home equity
Borrowing against your home equity may be a good option compared to using credit cards or personal loans. For one, you can typically get much lower interest rates with a HELOC or home equity loan. Depending on the amount you borrow, you could qualify for as low as 3% APR with a home equity loan or a HELOC. Lenders tend to be more willing to give borrowers lower rates because this type of loan uses your home as collateral.
Furthermore, using your home equity to take out a loan may mean that your interest payments are tax-deductible. Personal loans and credit cards do not have this advantage. However, you need to see if you can qualify for this tax deduction, as you can only deduct up to a certain amount. To take advantage of this, you’ll need to itemize your tax deductions, To see how much you may qualify for, check with a qualified tax professional.
Homeowners most commonly use home equity financing to consolidate their high-interest debts. If a home equity loan or HELOC has a significantly lower rate, you could save money by paying off your high-interest loans with these types of loans. Others use them for other major expenses, such as paying for a child’s college tuition, home repairs or medical bills. If you believe making major home improvements will significantly increase the value of your home, you may want to consider home equity financing as well.
Risks of financing using home equity
There are significant risks if you decide to borrow large amounts of money against your home.
Upfront costs. First off, taking out financing using home equity can be costly. Many of these costs could cost you hundreds of dollars to establish a loan. In addition, you may also need to pay extra fees, such as a transaction fee everytime you draw money from a HELOC. These initial charges could increase the cost of your loan and may put you at risk of you’re not prepared.
Risky rates. If you take out a loan with a variable rate, your monthly payments may change. If rates rise, you could find yourself with a larger monthly payment. Even if you take out a fixed-rate loan, you could put yourself at risk if you can’t afford the monthly payments. If your budget is already stretched to the max, you could find yourself falling behind on your payments. You can’t back out of the loan once you’re past the three-day cancellation rule. Some lenders also charge you a penalty for late payments, increasing the amount you owe.
Balloon payments. Also, some plans will set a minimum monthly payment that goes toward the principal plus interest. In other words, your monthly payments may not be enough to pay back the principal by the end of your loan term. If so, some lenders require you to pay this “balloon payment” in one lump sum when your payment plan ends. If you can’t do so, you put yourself at risk of defaulting on the loan.
Your home is at stake. Also, if you fall behind on your primary mortgage, your home equity loan provider will be notified. The lender may make payments to your primary mortgage lender and ask that you pay them back immediately. If you can’t do so, the home equity lender can legally foreclose on your home.
Yes, it can be tempting to have convenient access to large amounts of money, but it you may find yourself in hot water if you suddenly find yourself falling behind on your payments.
Which option is right for you?
When deciding between a HELOC and home equity loan, think about why you want to borrow money in the first place. If you need a large amount of money for a one-time expense or will use the loan to consolidate other debts, a home equity loan is probably your best choice. You just take out the exact amount you need and that’s it. However, if you’re not sure if you’ll have increasing expenses, such as a home improvement project or college tuition costs, you might want to go with a HELOC. That way, you’re only being charged interest in the amount you withdraw. It gives you the flexibility to have money there when you actually need or in case of an unexpected event.
Compare APRs. When shopping around for loans, it’s a good idea to compare APRs and other charges between loans to see which one provides the best deal. Keep in mind that APRs between home equity loans and HELOCs are calculated differently. For a home equity loan, the APR is calculated using the interest rate, points and other fees, such as closing costs. The APR for a HELOC is based on the interest rate during a set period of time and doesn’t include other charges, such as points and closing fees.
When comparing APRs, you’ll want to factor in other charges as well as the APR for a HELOC. You’ll also want to check to see how much rates could rise if you’re considering a variable-rate loan. Many lenders state in their terms a cap or a maximum rate you’ll be charged. Use that to predict how much you could be paying, as the APR could change after closing. Some lenders may let you switch from a variable rate to a fixed one for a HELOC. For example, your loan will convert into a fixed APR once the draw period is over. If that’s the case, you’ll want to factor in how much you could be paying throughout the loan.
If you like the predictability of fixed monthly payments, then a home equity loan may be your best choice. In this case, it’ll be easier to compare APRs between lenders since you’re essentially comparing apples to apples. If you’re looking for cheaper rates, variable rates typically offer lower rates, but only in the short term. You may want to consider this option if you plan on paying off the loan early or move homes within the introductory period. However, if you plan on staying in your home long-term, you risk having rates go up.
No matter which company you decide to go with, make sure to read over the loan estimate provided by the lender. This document outlines important details about the loan you’ve applied for. It should outline the terms you’ve discussed beforehand. If there are any discrepancies, or you’re unsure what something means, discuss it with the lender. The loan estimate will also have a Comparisons section so you can easily see how much a loan will cost you. This section will include things such as the interest rate, total monthly costs, upfront costs and how much you’ll need to pay during closing.
If you’re thinking about tapping into your home’s equity, think carefully about why you want to do so. It’ll help you figure out which type of loan you need and how much to borrow. You’ll want to shop around and compare all offers, including those from banks, credit unions, and online lenders. Compare all costs to find the best deal.
When all is said and done, you want to make sure you’re able to handle the monthly payments without stretching your budget too thin. If you can’t pay back the debt, you put your home at risk and you could face foreclosure. Through careful planning, a home financing loan is a great way to tap into your home equity and competitive APRs.