Both home equity loans and lines of credit offer ways to leverage the equity in your home and convert it into money you can use for improvement projects, new investments, or necessary purchases. While these financial options are similar, they’re not identical. Here is a look at how each type works, its potential pros and cons, and picking the product that matches your needs.
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What Is Home Equity?
Home equity is the amount of value in your home. It is calculated by taking the current market value of your home and subtracting the amount you have left in your mortgage. For example, if the market value of your home is appraised at $500,000 and you have $300,000 left on your mortgage, you have $200,000 in home equity.
Your home equity naturally increases over time as you pay down more of your mortgage. You can jumpstart your home equity by making a larger downpayment, such as 10% or 20% of the purchase price of your home, or by completing home renovations. It is also worth noting that your home equity may fluctuate over time in response to market demand. In practice, this means that if home prices in your area fall, your total home equity may shrink, while a sellers’ market may substantially increase your available equity.
Accumulated home equity can be used to access funds by taking out a home equity loan or applying for a home equity line of credit (HELOC).
COVID-19 Impacts On Home Equity Borrowing Options
Evolving pandemic pressures over the past two years have impacted home equity borrowing options, with some banks choosing to suspend HELOC and home equity loan applications in early 2020. While some have returned to business as usual, others are still looking to minimize market risk by choosing to limit or suspend home equity products.
In part, this is due to potential market corrections. Home prices soared during the pandemic, and there is concern that if housing bubbles burst, homeowners who took out substantial equity loans or lines of credit may not be able to meet their repayment obligations. As a result, some lenders are choosing to wait until the market stabilizes. For homeowners, this doesn’t mean that finding a HELOC or home loan is impossible, but that more research and comparison may be necessary.
What Is a Home Equity Loan?
A home equity loan is much like a personal loan: You apply for a specific amount, then your financial institution evaluates your application and approves or denies the loan. Once approved for a home equity loan, you receive the amount of the loan as a lump sum you can use however you see fit.
Home equity loans come with a fixed term of repayment and a fixed interest rate. You pay the same amount each month over a set repayment period with part of your payment each month going toward the principal and the bulk going toward the interest accumulated on the loan. When the term is up, the loan is fully repaid.
Given their similarity to mortgages, home equity loans are sometimes called second mortgages and offer a slow-and-steady approach to repayment.
Pros and Cons of a Home Equity Loan
Home equity loans come with several pros and cons, including:
Pros:
- Fixed-rate and term: Home equity loans have fixed interest rates and fixed terms, meaning you are not in the dark about how much you are paying or for how long. The length of your fixed term can be negotiated with your lender, and when the term concludes your loan is discharged.
- Secured loan: Home equity loans are considered secure debt because they leverage the preexisting equity in your home. This means you’re able to borrow higher amounts at a lower interest rate. It also means your home acts as collateral for your loan.
- Reasonable interest rate: Interest rates for home equity loans are lower than personal loans or credit cards. The rate for HELOANs is tied to the prime rate and varies based on your current debt load and creditworthiness.
Cons:
- Increased debt load: Home equity loans increase your total debt load, which can make it more difficult to apply for other loan products during their term. For example, if you also have a car loan and an additional line of credit and you use your entire HELOAN amount, you may not be able to apply for another loan until you’ve paid down some of the balance.
- Ongoing payment cycles: Lump sum disbursement can also lead to cycles of borrowing and repayment that see homeowners taking out new loans to pay down older ones, in turn putting them at risk of default. As a result, it’s worth making sure you have the resources and income available to meet payment schedules for HELOANs.
Requirements For a Home Equity Loan
For homeowners to qualify for a home equity loan, financial institutions consider several factors. First is the amount of equity in your home, which is determined after an appraisal. The exact amount varies, but banks may want to see 10% to 20% equity in your home before approving a loan.
Next is a solid credit score, followed by a low debt-to-income (DTI) ratio. Some banks may offer loans for DTIs under 43%, while others prefer a DTI lower than 35%. Additionally, banks consider your current source of income and your payment history with other loans and credit cards.
What Is a Home Equity Line of Credit (HELOC)?
A home equity line of credit (HELOC) is similar to a credit card. After successfully applying for a HELOC, you’re given access to a set amount of money that you can use at your discretion. Unlike a home equity loan, you can access as much or as little of this money whenever you need it. For example, if you have a HELOC of $50,000, you could choose to take out $1,000, $10,000, or $25,000 as needed, up to the full amount. HELOCs generally use a variable interest rate.
HELOCs are broken into two periods: The borrowing period — also called the draw period — and the repayment period. During the borrowing period, you can tap into the funds available, repay them, and use them again if you prefer. You make a monthly payment on any funds you have borrowed; some banks offer interest-only payment options during the borrowing period.
Once the borrowing period is concluded, you begin repaying the remaining balance. The repayment period is a fixed time period, such as 10 or 20 years, and you may be able to convert your balance into a fixed-rate loan.
Pros and Cons of a HELOC
HELOCs have several pros and cons, such as:
Pros
- Flexibility: HELOC funds can be accessed on demand, giving you control over how much you take out and how quickly you pay it back. For example, you could take out $1,000 to pay for an immediate expense, pay this amount back as soon as possible, and then withdraw the money again. You could repeat this process throughout the draw period.
- Low interest: HELOCs also come with lower interest rates than credit cards or personal loans because the loan is secured by your home. While HELOC interest rates are variable, which means they move up or down as the prime rate shifts, you may be able to convert them into fixed-rate loans when the borrowing period ends.
- May raise your credit score: Because you are making regular payments, you may be able to raise your credit score with a HELOC. In much the same way that your credit score raises when you make regular payments to your credit card, you could steadily increase your score with regular HELOC payments.
Cons
- Variable interest rates: HELOC borrowing periods have variable interest rates, which means they may increase or decrease over time. If the market experiences a housing bubble burst or world events impact prime rates, your rates may increase substantially.
- Potential account freezes: Depending on national and global financial conditions, your lender may freeze access to HELOC borrowing. For example, during the 2008 financial crisis, some banks put holds on HELOC funds to help prevent account defaults.
Requirements For a HELOC
Given their similar nature but different cash access and repayment approach, the requirements for a HELOC are similar to those of a home equity loan. A history of stable and steady repayments, existing equity in your home, a solid credit score, and a low DTI are factors in a successful application.
If you plan to acquire a larger HELOC over $100,000, your lender may require additional steps, such as providing a personal financial statement, paying higher closing costs, or acquiring a new title policy.
Home Equity Loan vs. Line of Credit At a Glance
Feature | HELOAN | HELOC |
|---|---|---|
Interest Rate | Fixed | Variable |
Interest Charged | Entire loan amount | Amount used |
Money Available | Immediate lump sum | As needed |
Payback Period | One fixed term | Draw period followed by repayment period |
Credit Score | No impact | Can increase your score |
Debt Load | Single increase | Depends on money used |
How Much Can You Borrow For a Home Equity Loan or HELOC?
While there are no hard-and-fast rules about how much of your home equity you can access with a home equity loan or HELOC, lenders may offer anywhere between 70% and 90% LTV.
In practice, this means that if your home is worth $400,000 and you have $200,000 left on your mortgage, you have $200,000 in equity. If you are able to borrow 90% in a HELOC or home equity loan, you can access $180,000. If 70% is the upper limit, you can borrow $140,000. Different lenders offer different rates depending on their qualification criteria, tolerance for risk, and your current financial circumstances.
Deciding Which Is Best For You: Home Equity Loan vs. HELOC?
Determining whether a home equity loan or HELOC is best for you depends on your current home equity, financial stability, and the intended purpose of your borrowed funds. If you are tackling a large home improvement project and have several hundred thousand dollars worth of equity in your home, it may make sense to apply for a home equity loan. You could use the lump sum to pay for contractors, materials, fixtures, and furnishings, and then leverage the low fixed-rate interest of a home equity loan to pay back the balance steadily over time.
If you have smaller projects in mind or want access to cash in hand in case of emergencies, a HELOC may make more sense. Since interest is paid only on money borrowed from the line of credit, it is possible to keep your balance low with targeted and controlled borrowing. And once you repay any money borrowed, you can use the full amount again up until the draw period is over and the repayment period starts.
The answer depends on whether you are looking for a lump sum with fixed-rate interest or on-demand access to cash with a specific borrowing period.