Home equity line of credit (HELOC) vs. home equity loan: How do they work?

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Home equity lines of credit (HELOCs) and home equity loans are loans that use your home as collateral, and both can be a great way to borrow money if you’ve paid down a significant portion of your mortgage. However, these two financial products don’t work quite the same. A HELOC is a line of credit that allows you to borrow money as needed with a variable interest rate, while a home equity loan is a lump sum that is disbursed up front and paid back in fixed installments.

Most home equity loans and HELOCs allow you to borrow up to 85 percent of the value of your home, minus your outstanding mortgage balance, and they typically have low interest rates and fair terms, since you’re using your home as collateral for the loan. Still, HELOCs and home equity loans are not all created equal. Before you settle on a home equity loan or line of credit, you should shop around to find an option with the lowest fees — or no fees if possible.

How the coronavirus is impacting home equity loans and HELOCs

With the Bureau of Labor Statistics reporting a 6.2 percent unemployment rate in February and many more people looking for work and additional cash flow, getting a home equity loan or line of credit while interest rates are still near all-time lows can be enticing for homeowners.

During economic uncertainty, however, banks rein in home equity approvals due to their high risk if borrowers can’t repay the loans and home values drop. A home equity loan or line of credit acts as a second mortgage; if a borrower gets laid off and defaults on the loan, the primary mortgage must be repaid first using the home’s current value (which might have dropped during a recession).

Only after the first mortgage is repaid in full can the home equity lender recoup the outstanding debt from whatever value is left from the collateral, which might be insufficient. Because of this, getting qualified for a home equity loan could be difficult while the coronavirus pandemic continues, and some lenders have halted their offerings altogether.

What is a home equity loan?

A home equity loan is a secured loan that lets you borrow against your home equity with a fixed interest rate and repayment term. The interest rate you’re approved for depends on multiple factors, like your credit score, payment history, loan amount and income. If your credit improves after you’ve obtained a home equity loan, you might be able to refinance to a lower interest rate or choose to pay the loan off early.

How can you use the money you receive from a home equity loan? It’s really up to you. Some consumers use it to pay for major repairs or renovations, such as adding a new room, gutting and remodeling a kitchen or updating a bathroom. Another common use is taking out a home equity loan with a low, fixed rate to pay off high-interest credit card debt.

How does a home equity loan work?

Home equity loans almost always come with a fixed interest rate and a fixed monthly payment. These loans are funded in a lump sum, and you’ll pay funds back over five to 30 years.

Generally speaking, you can borrow up to 85 percent of your home’s value, minus your outstanding mortgage balance. This means that if you have a home worth $300,000 and $100,000 left on your mortgage, you may be able to borrow up to $170,000 with a home equity loan.

Pros of home equity loans

  • Secure a low, fixed interest rate, fixed monthly payment and fixed repayment schedule.
  • Borrow a lump sum you can use for any purchase you want.
  • Some home equity loans don’t have any fees.
  • Loan interest may be tax deductible if used to remodel or improve your home.

Cons of home equity loans

  • The best home equity loan rates and terms go to consumers with good or excellent credit. “Good” FICO scores range from 670 to 739, while “very good” FICO scores are from 740 to 799; a FICO score of 800-plus is considered “exceptional.”
  • You need a lot of home equity to qualify — usually 15 percent to 20 percent or more.
  • If property values decline, you might be upside-down on your mortgage, meaning you owe more than your home is worth.
  • You could lose your home if you default on the loan.

What is a HELOC?

A home equity line of credit (HELOC) is a line of credit similar to a credit card. With this type of loan, you can borrow up to a specific amount of your home equity and repay the funds slowly over time.

Unlike home equity loans, HELOCs let you access money when you need it and repay it with variable interest. Because of this, you aren’t locked into a specific monthly payment. This can be good news for consumers who don’t know exactly how much they need to borrow and want to pay interest only on the money they access.

How does a HELOC work?

HELOCs have a draw period, or a period of time during which you can access the money, that typically lasts around 10 years. During this time, you’ll be responsible for interest-only payments. That’s followed by a repayment period, where borrowing must cease and monthly principal and interest payments are required. This repayment period usually lasts 10 to 20 years.

HELOCs tend to come with variable APRs, meaning your interest rate could go up or down based on market trends. The biggest risk with a HELOC is overborrowing — because you aren’t required to make payments to the principal during the draw period, you may be hit with high monthly payments once the repayment period begins, especially if you haven’t kept track of your withdrawals.

Pros of HELOCs

  • Only borrow as much money as you need.
  • Many HELOCs come without any fees.
  • Repayment options can be flexible.
  • You may be able to deduct the interest on your HELOC on your taxes if you use the funds to improve your home.

Cons of HELOCs

  • Variable interest rates can change with the whims of the market.
  • You can usually borrow only up to 85 percent of your home’s value, minus the balance of your first mortgage.
  • A long-term credit line risks overspending and a larger debt to repay.
  • You might lose your home if you default on the HELOC.

Home equity loan vs. HELOC: Key differences

Below are some of the major differences between home equity loans and HELOCs:

Home equity loan HELOC
Interest rates Fixed Variable
Monthly payments Same every month Varies over time
Average APRs Higher Lower
Funds disbursement Up-front lump sum As needed
Repayment terms Repayment starts as soon as loan is disbursed Interest-only payments during draw period; repay principal and interest afterward

How to choose between a home equity loan and HELOC

Home equity loans and HELOCs can both be good options, but one is probably better for your needs.

As you research, get quotes for both HELOCs and home equity loans to see which one might offer a lower interest rate, fewer fees and better terms. Also consider these scenarios where a specific option might leave you better off.

A home equity loan could be better if:

  • You know the cost of your project and need to borrow a lump sum of money.
  • You prefer a fixed interest rate that will never change.
  • A fixed monthly payment you can count on fits well into your lifestyle.
  • You want to consolidate high-interest credit card debt at a lower interest rate and pay it off with a fixed repayment plan.

A HELOC could be better if:

  • You want the ability to borrow as little or as much as you want — when you want.
  • You have upcoming expenses like college tuition and don’t want to borrow until you’re ready.
  • You don’t mind if your payment fluctuates.

Best ways to use a home equity loan or HELOC

There are few limits on how you can use your home equity loan or HELOC, but some of the best ways to use your loan include:

  • Paying down high-interest debt, including any credit card debt.
  • Simplifying your finances by reducing the number of bills you pay each month.
  • Completing a major home remodeling project.
  • Paying for major home repairs.
  • Helping pay for education tuition and fees.
  • Covering emergency expenses, like medical bills.

Also keep in mind that you may be able to deduct home equity interest on your taxes if you use your home equity funds to buy, build or improve your property. That makes these loan options a considerably good deal if you have home improvement projects on the horizon.

How do you get a HELOC or home equity loan?

While eligibility requirements for home equity products may have tightened up as a result of the coronavirus pandemic, there are still options available for eligible borrowers. Here’s an overview of what you’ll need to get a HELOC or a home equity loan:

  • Considerable equity in your home: You’ll likely need to have at least 20 percent equity in your home to qualify for a home equity loan or HELOC, or an 80 percent loan-to-value ratio — meaning your mortgage balance makes up no more than 80 percent of your home’s value.
  • Good credit: Having good or excellent credit is important to qualify for a home equity product, although specific lender requirements can vary. Some lenders also require a higher credit score for higher loan amounts. In general, you’ll want to have a credit score in the mid-600s to qualify and a score above 700 to score the best interest rates and terms.
  • A reasonable amount of other debt: Many lenders require a debt-to-income ratio of 43 percent or below to qualify for a home equity product. This means your monthly debt payments make up 43 percent of your gross monthly income or less.
  • Sufficient income: Your income is taken into account, since you need to prove you have the funds to repay your loan, although most lenders don’t disclose their income thresholds.
  • Reliable payment history: A long history of on-time payments on other bills can help you qualify for a home equity loan or a HELOC. If you have late payments on your record in the past, it’s likely that they damaged your credit score.

How to calculate your home equity

To find out how much home equity you have, subtract the amount you still owe on your mortgage from the value of your house. The difference is the amount of home equity you’ve accrued, and part of that amount can be used as collateral for a loan. You can also use a home equity calculator to find out more.

As an example, let’s say your home is worth $400,000 and you currently owe $285,000. In this case, you have $115,000 in home equity accrued, or 29 percent equity. This is generally enough to qualify for a home equity line of credit or home equity loan — most require you to have at least 20 percent equity.

With that being said, the amount of money you can tap varies based on your lender and if you’re considering a home equity loan or a line of credit. The maximum is typically around 85 percent of your home’s value, minus your mortgage balance, though some lenders will go as high as 90 percent. In the example above, 85 percent of your home’s value would be $340,000. Subtracting your mortgage balance would leave you with $55,000 available to tap through a loan.

The amount you should tap depends on what you’re hoping to use the money for; in general, try to tap the minimum amount you think you’ll need for your goals.

Can you have a HELOC and a home equity loan?

Theoretically, there is no limit to the number of home equity loans or lines of credit you can hold at one time. However, it will be harder to qualify with each new application, since you’ll have less and less equity to tap with each successive loan.

If, for instance, you have a home valued at $500,000 and you have two home equity loans totaling $425,000, you’ve already borrowed 85 percent of your home’s value — the cap for many home equity lenders.

Lenders may also charge higher interest rates on additional loans or lines of credit, especially if you’re asking for a second loan from the same lender. As with any loan product, it’s best to shop around with a few lenders before accepting a loan offer to make sure you’re getting the best rate possible.

Home equity loan vs. mortgage

Generally speaking, a mortgage is a first lien on your property, whereas a home equity loan or HELOC is a second lien on your home. This means that you use a mortgage to buy a property, and then use a home equity loan or HELOC later on to access the equity you’ve accrued on that property.

Mortgages also come with different borrowing requirements, which tend to be less stringent. For example, FHA mortgage loans let you borrow up to 96.5 percent of a home’s value when you purchase, and credit requirements are significantly looser as well.

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