Home equity loan and home equity line of credit (HELOC) guide

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Home equity loans and HELOCs may seem similar because they’re both ways to get the funds you need through tapping into your home’s equity, but they differ when it comes to funds, repayment and structure. Here’s a guide on equity loans, how they differ and when to utilize one over the other.

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What to know about equity loans

Also known as home equity loans or second mortgages, equity loans are loans that allow borrowers to borrow money by tapping into their home’s equity, or the value difference between the current market value and their remaining mortgage balance. Equity loans come in two forms: Home equity loans and HELOCs. In both, your equity acts as collateral for the lender, so if you fail to make the monthly payments, you run the risk of losing your home.

Generally, the total amount you can borrow is based on loan-to-value ratio (LTV) — how much you’re borrowing divided by the value of the property —  with a typical limit of 85 percent of your equity. However, the amount you’ll be granted is based on factors such as credit score, annual income and payment history.

Home equity loans operate similarly to a second mortgage and come with fixed, monthly payments. These loans can be used for things like home improvement projects, financing a college education, debt consolidation or long-term investments. HELOCs are lines of credit, making them useful for larger, long-term home improvement projects and typically come with a variable interest-rate, but some lenders may offer fixed-rate options.

Equity loans are useful if you have equity in your home and use it to finance a project that will increase the value of your home in the long run, or if you want to consolidate high-interest debt.

Eligibility requirements for home equity

While the eligibility criteria will likely vary depending on the lender, there are some general requirements that most lenders require. Here’s a list of standard requirements:

  • A debt-to-income ratio of at least 43 percent or less.
  • A good credit score, at least in the mid-600s.
  • A sufficient, steady income.
  • A history of on-time payments.
  • At least 15-20 percent equity in your home.

Home equity loans

A home equity loan is a secured loan that is backed by your home’s equity. They almost always come with a fixed repayment term between five to 30 years and a fixed interest rate that’s based on your financial history. Home equity loans are funded in one lump sum and can be used to finance any project, investment or purchase.

Over the course of your loan, if your credit score improves due to making the monthly payments in full and on time, your interest rate could be lowered, and if used to substantially increase the value of your home, the interest may be tax-deductible.

Pros of home equity loans

  • They typically come with lower interest rates than other forms of consumer debt.
  • If used in certain situations, interest can be tax-deductible.
  • You can use the funds in any way you wish.

Cons of home equity loans

  • Most have high home equity (15 to 20 percent) requirements.
  • You risk losing your home if payments aren’t made.
  • If your property value declines, you could end up paying more than your home’s value.

Home equity lines of credit (HELOC)

A home equity line of credit is an equity loan that operates as a line of credit and is similar to a credit card. You can borrow up to a certain amount and take out however much you need when you need it. With a HELOC, you’re not locked into a set repayment period and can make the payments when you withdraw funds. The interest rates are generally variable, but some lenders may offer fixed-rate options.

HELOCs have a draw period of 10 years and a repayment period that lasts typically between 10-20 years. During the draw period, you’re only required to make interest payments and can access the funds. During the repayment period, you can’t access your funds and are responsible for making both the interest and principal payments.

Pros of HELOCs

  • You can borrow only as much as you need.
  • The repayment options are flexible.
  • If used in certain situations, interest can be tax-deductible.

Cons of HELOCs

  • The variable interest rates can change at any time.
  • You risk losing your home if the payments aren’t made.
  • Due to it being a long-term line of credit, you risk having a larger debt to repay if spending isn’t closely monitored.

Home equity loans vs. HELOCs

Home equity loans can seem similar to HELOCs, but they are different ways to borrow money from your home’s equity. Here are some of the key differences between home equity loans and HELOCs.

Home equity loans                  HELOCs

Interest rates Fixed Variable
Loan terms 5-30 years Draw period: 10 years; Repayment period: Up to 20 years
Repayment terms Repayment begins once funds are disbursed Interest-only payments during draw period; principal and interest during repayment period
Funding Disbursed in one lump sum amount Withdraw any amount when needed
Monthly payments Same payment every month Varies based on time and the balance owed

 

Why use your home equity?

If you have a solid, steady income, a healthy credit history and are in good financial health, tapping into your home’s equity can be a convenient way to get the cash you need with lower interest rates. Because home equity loans are secured and backed by your home, they often come with lower interest rates than unsecured forms of debt, like credit cards or personal loans. It’s also common to use home equity loans to consolidate high-interest debt, as the low rates can save you money in interest in the long run.

Equity loan tax deductions

Due to the Tax Cuts and Jobs Act of 2017, whether or not you can deduct the interest charges depends on when you took out the loan, how much you borrowed and how you used the funds. To deduct the interest charges from your taxes, the loan must be used to “buy, build or substantially improve” the home backing the loan.

Joint filers that borrowed from their home’s equity after Dec.15, 2017, can deduct interest up to $750,000, and separate filers can deduct interest up to $250,000 worth of qualified loans. For joint filers that took out their home equity loans before Dec.15, they can deduct up to $1 million, and separate filers can deduct up to $500,000. These limits also apply to current mortgage loans as well, so if you have a current mortgage loan, this will cut into how much you’re able to deduct.

Home equity loans vs. refinancing

When you refinance, you take out a new mortgage loan that replaces your previous mortgage. Most borrowers refinance to score a lower interest rate or new terms, so it only makes sense to refinance if you’re offered a lower interest rate or a loan with better terms. You’re not responsible for paying off the first mortgage; the new lender will, and you’ll continue to make the loan payments as scheduled, just with a new lender.

Refinancing is also referred to as a rate-and-term refinancing or a cash-out refinance. Here’s the difference between the two:

  • Rate-and-term refinance changes the interest rate or term of the mortgage. Doesn’t involve tapping into equity for cash, and those with good credit are likely to benefit from a rate-and-term refinance.
  • Cash-out refinance gives the borrower cash for the difference between the two mortgages. A cash-out refinance only makes sense when the new mortgage covers a larger amount than the old mortgage.

Both refinancing and home equity loans are ways to get the funds you need through tapping into your home’s equity, but refinancing and home equity loans are used in different situations. Here’s when to consider refinancing, and when to take out a home equity loan.

When to refinance

Refinancing is best for borrowers who:

  • Are planning to stay in their current home for a substantial amount of time, or if the value of the home has increased.
  • Need a lump sum of money for larger, planned expenses.
  • Don’t have excellent credit.

When to take out a home equity loan

Home equity loans are best for borrowers who:

  • Have built up significant equity in their homes.
  • Have excellent credit scores.
  • Have a healthy financial and payment history.

How to get an equity loan

Here are 4 steps to follow when applying for a home equity loan:

1. Check your credit score, financial history and payment history

Before applying, make sure you know your credit score and check your debt payment history. If you have less-than-stellar credit and frequently miss payments, it will be harder for you to get approved. To increase your chances of approval, take steps to improve your credit score and if possible, improve your payment history by at least making the minimum payments on your current mortgage and debts.

Also calculate your debt-to-income ratio (DTI). If you have a DTI higher than 50 percent (at the most), it will be difficult to get approved for an equity loan. Focusing on paying down existing debt will lower your DTI, improve your credit score and improve your payment history.

2. Calculate your equity

To qualify for most equity loans, lenders will require you to have at least 20 percent equity — a maximum of 80 percent LTV– in your home to be eligible for approval. Before applying, calculate your LTV ratio by using a calculator, or by dividing the appraised value of your home by your current mortgage balance.

3. Consider the potential risks

Before applying, consider the potential risks associated with an equity loan. If you default on your loan, you could lose your home to the bank. Conduct an audit of your financial situation, and look at your previous payments. How well are you at keeping up with your mortgage payments?

If you’re not on top of your monthly payments or have trouble keeping your payments organized, talk with a financial advisor to help you decide whether or not a home equity loan is too risky for your personal financial habits.

4. Compare lenders

Compare equity loan lenders by shopping around to find the most competitive rates and terms for your financial situation. Once you find the lender that meets your needs and offers the best rates, check the eligibility requirements to make sure you qualify. Then you can start the application process, which can be done online or in-person if financing through a bank or credit union.

To ensure a smooth application process, make sure you’re familiar with the required documentation and that you have what you need during the application.

Loan payback help

If you’re having trouble making your monthly equity loan payments, contact your lender as soon as possible before defaulting on your loan. Once you default, that’s when you risk losing your home, and some lenders may offer forms of relief like lowered interest rates, adjusted repayment terms or forbearance options. While this isn’t a given for every lender, it’s worth checking before your loans enter into default status.

Once your loans have entered into default status, your lender will constantly reach out to you via phone calls, letters or emails. If you receive a notice, reach out immediately. There’s a chance that the lender may be willing to adjust your loan or repayment term if you can prove that you’re now able to make the monthly payments.

Helpful home equity resources

Here are some resources to help you navigate the confusing process of borrowing a home equity loan:

Helpful HELOC resources

Here are some resources to help you navigate the confusing process of taking out a home equity line of credit:

Final considerations

While borrowing from your home’s equity can be a risky move, it can pay off in the long run if you’re dedicated to making the payments. Equity loans are great ways to borrow large sums of money for lower interest rates and can provide substantial long-term benefits.

If you’re unsure whether to borrow a HELOC or a home equity loan, speak with a financial advisor to help determine which option best suits your financial situation, and if an equity loan is a good idea in general. If a home equity loan is too risky or doesn’t work for your needs, you can apply for unsecured methods of borrowing like personal loans or credit cards to get the financing you need.

Next steps

Once you’ve decided that an equity loan is the financing route you want to go, conduct a financial audit to determine which equity loan works best for you. Research the risks and benefits before applying, and compare lenders to find the most competitive rates for your situation. In the right situation, equity loans can be the best way to get the funds you need.

Written by
Hanneh Bareham
Student loans reporter
Hanneh Bareham specializes in everything related to student loans and helping you finance your next educational endeavor. She aims to help others reach their collegiate and financial goals through making student loans easier to understand.
Edited by
Loans Editor