June 24, 2021

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HELOC vs. home equity loan: Which is right for you?

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Home equity loans and HELOCs: An overview 

Plenty of Americans are richer in home equity than they were a year ago, thanks to rising home values in markets across the nation.

A home equity loan or home equity line of credit is one way to tap your home’s cash
value.

Both these loan types are secured against your home, so they charge much lower interest rates than other borrowing options — like personal loans or credit
cards.

But which of these second mortgage loans
do you need? Or should you consider a cash-out refinance to replace your
existing mortgage instead?

Check your home equity financing options (Feb 4th, 2021)


In this article (Skip to…)


What is a second mortgage?

Also referred to as a ‘second mortgage,’ a home equity loan or home equity line of credit (HELOC) lets you access part of your equity without selling the home or refinancing your existing mortgage loan.

When you apply for a home equity loan or HELOC, your current equity determines how much you can borrow.

As a refresher, equity is the value of your home minus what
you owe on your mortgage. If
you own a $300,000 home and owe $200,000 on your mortgage, you have $100,000 in
equity.

How home equity loans work

Like your current mortgage, a home
equity loan would be an installment loan with a fixed interest rate that pays out a
lump sum upfront. You’d
make monthly payments, based on a repayment schedule, to pay off the loan.

But unlike your
current mortgage — the one you used to buy the home
— you could spend the funds
from a home equity loan in any way you like.

You could even use the money for expenses
not related to your home. For example, borrowers often use home equity loans to finance major
expenses such as:

  • Debt consolidation
  • Medical bills
  • College education
  • A second home
  • Home repairs
  • Home improvement projects

A home equity loan is a versatile
financial product, but it’s
important to remember you
can’t use the same equity over and over. These are
secured loans, meaning you’re
tying up your equity as collateral.

When you get a home equity loan, a
“lien” is created against your house and reduces your actual home equity. If you sold the home before paying off the
home equity loan, you’d have to repay both your primary lender and your home
equity lender.

A lien also gives your lender the right to foreclose on your home if you can’t repay the loan as agreed. So, as with any mortgage loan, there are risks involved.

How home
equity lines of credit work

Like a home equity loan, a home equity
line of credit (HELOC) taps your home’s existing value to generate cash you can
use for any purpose you’d like. 

But compared to a home equity loan, a
HELOC has a few key differences:

  • A HELOC is a credit line which you can draw from and then pay back repeatedly, much like you would a credit card. Since your home’s equity backs the credit line, you’d pay significantly less in interest compared to a credit card
  • HELOCs typically have variable interest rates tied to the prime rate, so payments won’t be as predictable as a home equity loan’s fixed payments. HELOC payments are also based on the amount of the credit line you have in use each month
  • There are few, if any, closing costs for HELOCs. The lender often covers the origination fee

HELOCs can extend credit as you need it,
so they provide ideal financing for ongoing projects. Often, borrowers can move
money from their HELOC into a checking account within minutes.

But a HELOC won’t last indefinitely. At
some point — usually after 5 or 10 years — your HELOC’s draw period will end
and you’ll have to follow a repayment schedule.

Some HELOC borrowers convert their lines
of credit to home equity loans when they’re finished drawing from the credit
line. 

How much can I borrow with a
home equity loan or HELOC?

Not all lenders offer home equity loans or
HELOCs. And the ones that do typically limit the amount you can borrow
to only a portion of your home’s equity.

Let’s look again at a $300,000 home with a
$200,000 mortgage. The owner of this home would have $100,000 in home equity.

But odds are, the homeowner could borrow
only about $55,000 of that equity through a second mortgage. 

Why such a small amount? Because mortgage lenders enforce loan-to-value requirements, which limit the amount of your home’s value that can be tied up in mortgages.

Calculating your maximum home equity loan amount

Loan-to-value (LTV) calculations can be
confusing because they apply to both mortgage loans — your existing mortgage as
well as the new home equity loan or HELOC.

For example, an 85% loan-to-value maximum
on a $300,000 home means the homeowner can hold only $255,000 worth of
mortgages ($300,000 x 0.85 = $255,000).

Since the primary mortgage has a $200,000 loan
balance, that leaves only $55,000 for the second mortgage.

Here’s a simple breakdown of this math
from start to finish:

  • Home’s appraised value: $300,000
  • Mortgage loan balance: $200,000
  • Equity in your home: $100,000
  • Calculate 85% of your home’s current value: $300,000 x 0.85 = $255,000
  • Subtract the $200,000 that you currently owe
  • Total equity available to borrow: $55,000 

Not all homeowners will be
able to borrow the maximum amount of equity available, either.

Other factors that affect your borrowing power

Lenders also look at
factors like your credit score, credit report, and debt-to-income ratio to
determine how large of a loan you qualify for — just like they did when you
bought your home.

In addition, the example above assumes
you’ll have only two liens — the primary mortgage and the new home equity loan
or HELOC. A third lien would limit borrowing power even more.

Because of these limits, you’ll probably need to build up a good
amount of equity in your home before you’re able to borrow a large amount of
money.

Fortunately, increasing home values have sped up the
process of accumulating equity for many homeowners over the past year.

Check your home equity financing options (Feb 4th, 2021)

Home equity
loan vs. HELOC? What’s better for you?

When you’re ready to borrow against your
home’s equity, you will
likely have three choices:

  1. A fixed-rate home equity loan
  2. A variable-rate home equity line of credit (HELOC)
  3. A cash-out refinance loan

Let’s look at how these options compare.

Fixed-rate
home equity loan

Simply put, a home equity loan is another mortgage
loan that’s usually smaller than your current mortgage. You’d receive the total amount you intend to borrow in one lump sum and
pay it back every month.

The repayment schedule for a home equity loan is typically 5-15 years. Since it’s an installment loan, the payment and interest rate remain the same over the
lifetime of the loan.

Also, a home equity loan must be repaid
in full if the home is sold.

Adjustable-rate
home equity line of credit (HELOC)

A HELOC uses your home equity to fund a credit line which you can
draw from as needed.

During the draw period you can use your
HELOC like you’d use a credit card, but without the high-interest debt to worry
about. Also during the draw period, you can choose to repay loan principal or
only make interest payments each month, depending on your financial situation
at the time.

The draw period (typically 5 to 10
years) is followed by a repayment period of 10 to 20 years, during which you can no longer withdraw funds and
must repay any outstanding balance in full with interest.

Cash-out
refinance

Unlike a home equity loan or HELOC,
a cash-out refinance replaces your existing mortgage with a whole new loan.

The new loan balance is larger than
what you currently owe, and the difference is cashed-out to you at closing
(minus closing costs).

Since a cash-out refinance is a first mortgage (not a second mortgage), it will typically offer lower interest rates than a HELOC or home equity loan. And requirements can be more lenient, too. FHA cash-out loans are even available with a credit score as low as 600.

On the downside, a cash-out refinance starts your loan over, so it may increase your total interest cost over the life of the loan.

The long-term cost depends on how much time is left on your existing mortgage and how low your new interest rate is compared to your old one.

Find the right loan for you (Feb 4th, 2021)

Pros and
cons of home equity loans and HELOCs

As you decide between a HELOC and a home equity loan, consider the pros and cons of both types of borrowing. 

Home
equity loan pros:
 

  • Fixed interest rate and fixed payments
  • Simplicity of an installment loan
  • You can lock in at today’s low mortgage rates
  • Single disbursement is ideal for big projects, purchases, or debt consolidation

Home
equity loan cons:

  • Less flexibility than a home equity line of credit (HELOC)
  • Interest is charged on full loan amount, no matter how much of it you use
  • Lenders may require higher credit scores than for traditional mortgages
  • Not all lenders offer these loans
  • Closing costs can be higher than for HELOCs

HELOC
pros:

  • Interest charged only the amount drawn from the line of credit
  • Can be paid off and re-used throughout the draw period
  • Ideal for ongoing or not-yet-planned projects
  • Some lenders charge no closing costs 

HELOC
cons:

  • Variable interest rates make repayment less predictable
  • Variable interest rate can increase your total cost if the prime rate rises
  • Line of credit ties up equity even when you haven’t drawn from it   

Which second
mortgage loan is best for you?

So what’s your best option: home equity
loan or HELOC? Jed Mayk, attorney and partner with Hudson Cook, LLP says that
depends on your needs.

“A home equity loan might make more sense
for a borrower who needs a set amount of money for a specific purpose,” he says.
“This can include a home improvement project.” 

A home equity loan also tends to be a
better fit for needs such as: 

  • Debt consolidation
  • Extensive home renovation requiring a large upfront payment
  • Investing in real estate

But a home equity loan may not be the best
choice “if you are unsure of the exact amount you may need now or in the
future,” says Johnna Camarillo with Navy Federal Credit Union.

A HELOC might make more sense for those
who need to borrow different amounts over a period of time, says Mayk.

Examples of good uses for HELOCs include:

  • Regular tuition payments
  • Extended “pay as you go” home improvements
  • Providing emergency cash flow for a new business

HELOCs are best for those who don’t need
instant access to their home’s equity.

“A HELOC can be used like a credit card.
It’s great to have as a rainy day fund if your home needs emergency repairs,”
Camarillo says.

Mayk says HELOCs are also popular with
folks who have irregular income patterns. “This includes those paid a base
salary and quarterly commissions.”

Other HELOC and home equity loan matters to consider

You need a good credit
score to take advantage of either a HELOC or a home equity loan. 

“A score of 620 or lower will make it hard
to secure a [home equity] loan or HELOC,” says Theresa
Williams-Barrett of Affinity Federal Credit Union. “Higher scores may
provide access to higher loan amounts and lower costs.”

You also need to be confident in your
earnings and job security. “Establishing a secure, constant source of
income is very important,” Williams-Barrett says.

In addition, note that interest paid on home equity loans and HELOCs may or may not be tax-deductible. Check with a tax professional.

Additional
ways to borrow from home equity

HELOCs and home equity loans (sometimes called
HELOANS) aren’t the only ways to borrow against the value of your home.

Cash-out
refinance

Rather than taking out a second mortgage, a cash-out refinance replaces your existing home loan with a new, larger mortgage.

The new loan is used to pay
off your current mortgage, and the ‘extra’ amount is cashed out to you at
closing.

Most mortgage lenders cap the amount you can borrow on a cash-out refinance at 80% of your home’s value. (The exception is VA cash-out refinancing, which allows a 100% loan-to-value ratio.)

Back to our example of a $300,000 home
with $200,000 still due on the mortgage:

  • Home value: $300,000
  • Maximum refinance loan amount: $240,000 (0.8 x 300,000)
  • Subtract existing mortgage balance: $240,000 – $200,000
  • Maximum cash-out: $40,000 (minus closing costs)

Cash-out refinancing has some distinct
benefits. It gives you one mortgage payment instead of two; interest rates are
typically lower than for home equity loans or HELOCs; and if you’re paying a
higher interest rate on your existing mortgage, you could save a lot by locking
in a lower rate or a shorter term.

“This is an attractive option if doing so
lowers your interest rate,” Camarillo suggests.

But keep in mind that refinancing starts
your loan over at day one. If you’re almost done paying off your current
mortgage, a home equity loan or HELOC might make more sense.

Convertible
HELOC

Convertible HELOCs come with an additional
feature — the conversion option.

At some point during the loan’s lifetime,
you could convert your variable-rate HELOC to a fixed-rate home equity loan.

Your HELOC may already have a conversion
option; some even give you more than one chance to convert during the life of
the loan.

Keep in mind this may not be a great deal. The fixed-rate repayment period after the conversion may be longer, stretching out interest payments over a longer period of time. Also, at times, a variable interest rate is preferred to a fixed rate. And a convertible HELOC may charge higher fees.

Still, this is an option worth considering if you’d like a hybrid between a variable-rate HELOC and a fixed-rate HELOAN.

When shopping for a HELOC with a
conversion option, ask lenders these questions:

  • Is there a charge for the conversion? If so, how much is it?
  • Will I be able to use the remaining credit available on the line after a conversion?
  • Does the loan convert to a new fixed loan (for example, with a 30-year term), or is the balance amortized over the remaining term of the existing loan?
  • How many times can I convert?
  • How often can I convert?
  • What determines the new fixed interest rate?

As always, make sure you fully understand the terms of the loan and the total long-term cost before signing on.

Home
equity loan vs.
HELOC FAQ

What is home equity?

Home equity is the portion of your home’s value that you own. Put another way: It’s the amount of your home’s value you don’t owe to a lender. To calculate your equity, subtract the amount you owe on your current mortgage from the market value of your home. The amount of equity in a home fluctuates over time as you pay down your mortgage loan and as the value of the property goes up or down.

How much can you borrow against the equity in your home?

Homeowners can typically borrow 80–90% of their home’s appraised value using a home equity loan — minus what is owed on their first mortgage. This amount can vary according to your credit score.

How do home equity loans and HELOCs work?

A home equity loan is a second mortgage. Just like your primary mortgage, the home’s value serves as collateral for the lender. Home equity loans are paid off in installments of principal and interest over a fixed repayment period. A home equity line of credit (HELOC) is a bit more complex. You can draw from the line of credit and make payments only on the amount withdrawn. As with any mortgage, if the loan is not paid off and the home enters foreclosure, the home could be sold to satisfy the remaining debt.

Are home equity loans and HELOCs a good idea?

A home equity loan can be a good way to convert the equity you’ve built up in your home into cash, especially if you invest that cash in home renovations that increase the value of your home. But always remember, you’re putting your home on the line. If real estate values decrease, you could end up owing more than your home is worth. Should you then want to relocate, you might end up losing money on the sale of the home or be unable to move. 

Does a home equity loan hurt your credit?

Home equity loans may impact your credit score. However, home equity lines of credit (HELOCs) tend to have a bigger impact on credit scores. Whether the impact is positive or negative typically depends on how much you owe compared to the available credit limit.

What credit score is required for a home equity loan?

Most lenders require a minimum credit score of 620 for a home equity loan. Other lenders may require scores as high as 700. As with other mortgage loans, the better your credit score, the better your interest rate and loan terms.

Are home equity loans tax-deductible?

The interest paid on a home equity loan or HELOC might be tax deductible if the funds were used to “buy, build, or substantially improve your home.” If the funds were not used for any of these purposes, interest is not tax-deductible. In addition, you can only deduct mortgage interest if you itemize your tax deductions instead of taking the standard deduction. If you’re not sure how to handle your taxes, consult a tax professional.

Is there a penalty for paying off a home equity loan early?

Most home equity loans do not have a prepayment penalty. However, some HELOCs do have penalties that are designed to recapture loan closing costs your lender may have originally waived.

Should you
consider a home equity loan?

With home values on the rise, many
homeowners have gained a lot of equity in their existing homes over the past
few years.

Home equity loans and HELOCs can be
affordable ways to unlock this equity without replacing your existing mortgage.
Compared to other forms of borrowing, such as high-interest credit cards or
unsecured personal loans, these loans can provide attractive interest rates.

But you’re putting your home on the line
to get these low rates. You owe it to yourself to use this borrowing power
thoughtfully. 

And be sure to shop around to get the best
rates with today’s top lenders.

Verify your new rate (Feb 4th, 2021)

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