Sometimes life throws you a financial curveball. Maybe your credit card bills have gotten away from you, or you need to do an expensive roof repair. You need a big chunk of cash that you don’t have.
You may want to consider using the equity in your home to tap into some funds. This is called home equity debt. Your equity is the difference between how much your home is worth and how much you still owe on your mortgage.
Types of home equity debt
|Home Equity Loan||Home Equity Line of Credit|
|Type of interest:||Fixed-rate||Variable-rate|
|Repayment term:||5 – 15 years||15 – 20 years|
|Payout:||Lump sum||Revolving credit|
|Type of loan:||Secured||Secured|
|Best for:||Debt consolidation, major renovation costs||Minor renovation costs over a number of years|
There are two types of home equity debt: home equity loans and home equity lines of credit, also known as HELOCs. Both are sometimes referred to as second mortgages, because they are secured by your property, just like the original (or primary) mortgage.
So, what’s the difference, and how does a home equity loan work compared with a HELOC?
“A home equity loan is a fixed-rate installment loan where all the money is borrowed in one lump sum at inception and repaid in even monthly payments (or installments) over the term of the loan,” says Greg McBride, CFA, Chief Financial Analyst for Bankrate.com.
“By contrast, a home equity line of credit has a variable interest rate but offers a great deal of flexibility on both the borrowing and the repayment. During the initial draw period, typically 10 years, the homeowner can borrow funds only when they’re needed and has discretion over whether to make a minimum interest-only payment or to pay down the balance more aggressively.”
Here’s what you’ll need for a home equity loan/HELOC:
- Minimum credit score of 620
- Loan-to-value ratio of 80% (20% equity in your home)
- An approximate amount you want to borrow
There are many differences between home equity loans and home equity lines of credit. But if you’re just beginning to shop around, you can prepare for both.
First, check your credit score. If your credit score is under 620, it may be difficult to qualify for a home equity loan. And the minimum credit score for a HELOC is typically higher.
Lenders generally require a minimum loan-to-value ratio of 80%, or 20% equity in your home. Loan-to-value ratios compare the worth of a loan against the value of property put up as collateral. In other words, lenders want to see that you’ve paid down 20% of your original mortgage or other loans.
Lastly, when shopping around know how much you want to borrow. Even if the numbers aren’t clearly defined, give as close an approximate as possible. Home equity loans/HELOCs are long-term loans, and require years to repay. Don’t borrow more than you need.
How does a home equity loan work?
Once you secure a home equity loan, your lender will pay out a single lump sum. You can use the money to finance home renovations, consolidate credit card debt, etc. But once you’ve received your loan, you have to start repaying it.
Home equity loans have a fixed interest rate. That means you’ll pay a set amount, every month, for a predetermined period of time. Your interest rate and terms will not change for the length of the loan.
How do home equity lines of credit work?
HELOCs are a bit more complicated. They’re split into two parts: the draw period and the repayment period. HELOCs typically come with variable interest, meaning that interest rates can change from month to month.
Once you’ve secured a HELOC, the draw period begins. You’ll be able to draw money as you need it, when you need it. Draw periods last an average of 10 to 15 years. During the draw period, you’ll be restricted to interest-only payments.
After the draw period comes the repayment period. During the repayment period, monthly payments include both principal and any remaining interest. Repayment periods tend to be longer than draw periods, lasting anywhere between 15 to 20 years.
How to choose which is right for you
Now that you know the why and the how, does a home equity loan work better for you than a home equity line of credit?
Consider what you plan to use the money for.
Home equity loans are best for those seeking debt consolidation or making a big-ticket purchase, McBride says. Because they’re a one-time loan, they aren’t subject to fluctuating interest rates, so your monthly payments remain the same throughout the life of the loan.
Eligibility criteria may be stricter for these types of loans. For example, if the value of your home has decreased, you won’t be eligible for a home equity loan.
A home equity line of credit, or HELOC, works more like a credit card because it has a revolving balance. This type of loan might be best for someone who has several large payments due over time, like with a big home improvement project,
A HELOC allows you to borrow up to a certain amount for the life of the loan — a time limit set by the lender. During that time, you can withdraw money as you need it. As you pay off the principal, you can use the credit again.
Although the money from a HELOC can be used more flexibly than a home equity loan, the amount of interest you’ll have to pay is a variable-interest rate that fluctuates over the life of the loan, which means you could end up paying steep interest charges if rates rise over time.
Things to consider with both
With either a home equity loan or a line of credit, you’re pledging your home as collateral, meaning if you don’t make the payments on your loan, the lender could end up owning your house.
Equity loans and lines of credit often have a repayment period of 15 years, although it might be as short as five and as long as 30 years.
And, even if you end up selling your house, you still have to pay off the balance of the loan before the title can be transferred.