A home equity line of credit or home equity loan can help you borrow against the equity in your house to finance repairs or renovations that will increase your property’s value. But uses may also include consolidating debt, paying for college and handling other large expenses.
HELOCs and home equity loans are considered second mortgages, which you get when you have a first mortgage – the primary loan taken to purchase a property. Each loan is financed with your home as collateral, and you will need to pay both to avoid foreclosure. You may later choose to refinance your first and second mortgages into one interest rate and one payment.
Record-low mortgage rates could open the door to a home equity loan or HELOC, although second mortgage interest rates are generally about 1 percentage point higher than first mortgage rates, says Bill Dallas, president, Finance of America Mortgage.
Which type of financing is best may depend on your plans for the loan and your finances. The caveat is that COVID-19 may affect the availability of HELOCs and home equity loans as banks toughen lending requirements and pause applications to reduce their risk during the downturn.
A second mortgage is riskier for lenders because if a borrower defaults on the first mortgage, there may not be enough money left after the home is sold to pay both loans. But if you have solid credit and stable employment, a home equity loan or HELOC could be a good choice.
Here’s more about how you can compare home equity loans and HELOCs and pick between the two.
What Is the Difference Between a HELOC and a Home Equity Loan?
The major difference between a home equity loan and a HELOC is how you access equity in your property, explains Julienne Joseph, assistant director of government housing programs and member engagement at the Mortgage Bankers Association, which represents the real estate finance industry.
A HELOC is similar to a credit card and allows you to borrow against your home’s equity to use when you need it. The lender gives you a credit limit to draw from, and you will only repay what you borrow, plus interest.
A home equity loan, on the other hand, is an installment loan. You receive a lump sum, with home equity as collateral, and make fixed payments until the loan is paid off.
“The attractive feature of a HELOC is that it’s revolving credit, so you can continue utilizing it without reapplying to access funds,” Joseph says. “With a home equity loan, you get one shot at the money. You’ll have one fixed payment per month, so you’ll pay in installments vs. having the revolving credit of a HELOC.”
Home equity loans have fixed interest rates based on your creditworthiness. You’ll owe the same amount to the lender every month until the loan is paid off, which could be as long as 30 years.
HELOCs, though, have adjustable interest rates, which means that rates – and payments – can change periodically based on market conditions. Compared with a home equity loan, a HELOC may initially have a lower interest rate but can rise and increase your payment.
Some lenders may also specify a period of time in which a HELOC has a fixed rate.
Whatever you choose, HELOC or home equity loan, you are adding to your debt load. “Whenever you borrow money, consider what expenses you are using the equity for,” Joseph says. “You are, in fact, increasing the balance due on your home and using it for collateral.”
Which Is Better: HELOC vs. Home Equity Loan?
The best way to borrow may boil down to whether predictability or flexibility is most important to you: A home equity loan provides predictability, and a HELOC offers flexibility.
With a home equity loan, you know exactly what your payments will be and when you will pay off the loan. If you choose a HELOC, your payment and your loan balance can rise and fall over time to correspond with market rates.
Another difference between the two is that a home equity loan gives you a lump sum upfront, while a HELOC allows you to borrow as much as you need on your own timeline.
“If you take out 70% of your equity in a loan – meaning there is one shot at the money and you receive one disbursement – a significant portion of your equity is now tied up for some time,” Joseph says. “Are you prepared to not tap into that equity again until you fully pay off the equity you borrowed?”
A HELOC may be a better option if you don’t know the precise amount you will need to borrow or have long-term obligations, such as college tuition payments. You can control how much of your credit line to use, repay it and borrow it again as many times as you want during the draw period.
The HELOC draw period is the amount of time borrowers have to access money from their line of credit, typically 10 years. After that, you’ll enter the repayment period, which is generally 15 to 20 years.
A HELOC can be a safety net for emergency expenses, Joseph says. “Some people will take out a home equity line of credit to fund some home improvements, and once they pay it off, they keep the credit line so they know they have it in case of emergency – and that makes them feel more comfortable,” she says.
Others prefer a home equity loan because a line of credit could lead to overspending, Joseph says. “Once they use the funds and pay it back, there is not a temptation to rack up debt.”
HELOCs and Home Equity Loans: Pros and Cons
Weigh the pros and cons of a HELOC and a home equity loan to help you choose the right one.
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How Much Home Equity Should You Borrow?
Generally, you can borrow up to 80% of your loan-to-value ratio, a measure comparing the amount of your mortgage with the appraised value of your property. But just because you can borrow that amount doesn’t mean you should.
Say your home is worth $200,000, and you owe $100,000; your LTV is 50%. If you borrow up to 80% of your LTV, which would be a HELOC or home equity loan of up to $60,000, your equity will be almost fully leveraged. If your property value drops, you’ll owe more on your property than it is worth.
If you’re concerned about pulling out too much equity at once, a HELOC could allow you to open a credit line but only use what’s needed.
The good news is you can expect your home’s equity to grow over time. Even as the coronavirus has led to soaring unemployment rates and missed mortgage payments, home values continue to increase and help homeowners get more equity.
Although equity continues to grow, you will still want to be cautious about how you use a HELOC or home equity loan. The key is to use the funds wisely and not take out too much equity so you can preserve the value of your home. Dallas emphasizes: “If you want financial independence, use equity properly.”