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Housing is usually the most significant expense of our life. However, it's also an investment in a better future. Besides having your own place to live in, owning a house can help you finance major purchases or even renovate homes. All these become possible thanks to home equity loans and lines of credit.
Despite looking similar, there's a critical difference between a home equity loan and a home equity line of credit. This article will help you understand how both work and choose the one that better suits you.
What Is Your Home Equity?
Home equity refers to the portion of your property's value you actually own. It's calculated by deducting the amount you owe on your mortgage from the total house price. Gaining equity typically starts with making a down payment on your mortgage. Then, your equity will grow every time you make your monthly mortgage payment. Another way your equity can change is if your Home's market value fluctuates over time. This can happen due to changes in economic conditions, the real estate market, and home improvement or renovation.
Different Types of Home Equity Loans
Home equity financing, which uses your home equity as collateral, offers three main options:
- A home equity loan. This borrowing type is like a secured personal loan in home equity financing.
- A home equity line of credit. Think of it as a revolving credit line backed by your equity.
- A cash-out refinance. A cash-out refinance is a new mortgage for a more significant amount, so you can cover your current home loan and get a certain sum left on hand.
Let's take a closer look at each option, explore their differences, and find out which one will work better for your specific needs.
What Is a Home Equity Loan?
Your Home's equity backs a home equity loan. This borrowing type is also known as a second mortgage. With its help, you can get up to 80% of the property's value you own. The sum will be given to you as a lump-sum deposit. Then, you start repaying the loan in fixed monthly installments within 5 to 15 years. Some lenders may even offer home equity loans with up to 30 years of repayment.
A home equity loan typically has a fixed interest rate. This makes your monthly payments predictable, as your APR won't fluctuate over the loan life, even if economic conditions change. However, you need to be aware of the risks this loan carries. If you default, the lender can foreclose your property and sell it to cover your unpaid debt.
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Home Equity Loan Requirements
Before approving you for a home equity loan, lenders will pay special attention to your overall financial health. Here are some factors they will consider:
- Your credit score. While a home equity loan is a secured loan, it usually has more relaxed credit score requirements than unsecured options. This makes getting a home equity loan with bad credit possible. However, some minimums may still exist. Some lenders will ask applicants to have a FICO rating of at least 670, while others may accept borrowers with scores as low as 620. Just keep in mind that a lower credit score may result in a higher equity requirement;
- The amount of equity you own. Most lenders require you to own at least 15% to 20% of your property's cost. Professional appraisers make the whole home appraisal part of the application process. Based on their assessment, a lender can determine the percentage of equity you own and decide how much money you can borrow;
- Debt-to-income ratio. Your debt-to-income (DTI) ratio shows how much debt you carry compared to what you earn monthly. A ratio of no more than 43% is typically required to qualify for a home equity loan. Some lenders may even ask you to have a DTI of 30%;
- Income. Despite providing collateral, you must prove that your income is high enough to cover your monthly payments, significant living expenses, and current debts. Each lender may set its minimum income requirement. However, the sum you earn needs to be adequate for the requested loan amount.
Pros and Cons of Home Equity Loans
Like any borrowing option, home equity loans have advantages and downsides. Here's a detailed review.
Pros:
- Access to more significant amounts. A home equity loan can provide more financing compared to unsecured loan options;
- Fixed interest rates. Fixed rates mean fixed payments, making your loan predictable;
- Tax perks. If you use the loan to buy, build, or improve your primary residence or second Home, your interest rates will be tax deductible. For loans obtained after December 15, 2017, the amount you can deduct is up to $750,000 worth of qualified loans;
- No loan purpose restrictions. You can use the loan funds at your discretion, as lenders don't track the way you spend the money;
- Lower minimum credit score requirements. Lenders can reduce their credit score minimums as home equity loans are secured. Some of them even accept lousy credit borrowers.
Cons:
- You put your property at risk. If you become unable to make your monthly payments, a lender may foreclose your house;
- Closing costs may be charged. Some lenders require you to pay closing costs of 2% to 5% of your loan amount;
- No draw, period. You start repaying your home equity installment loan when you get the funds.
What Is a Home Equity Line of Credit?
A home equity line of credit (HELOC) comes in the form of a revolving credit line provided against the value of your property. You can borrow money within your credit limit as needed and pay interest solely on the amount you've used.
Home equity lines of credit have draw periods and repayment periods. A draw period may be up to 10 years. Within this term, you can use the money, then repay it, and take out the funds again. Another benefit is that you will have to make only interest payments without covering a principal loan amount. Thus, a draw period is usually marked by low monthly payments.
The repayment period begins after the draw period ends and can last up to 20 years. Within this term, you're not allowed to use money. The repayment period comes with the transition to principal-and-interest payments, so the amount you pay monthly will increase significantly.
Types of HELOC
A HELOC is considered to be a separate subtype of home equity financing. However, it can be divided into a fixed-rate and a variable-rate line of credit.
Variable-rate HELOC
Most HELOCs have a variable interest rate that can change under certain economic conditions. If your interest rate rises, your total loan cost and monthly payment will increase. Although a variable interest rate may be initially lower compared to a fixed one, it still carries more risk to a borrower.
Fixed-rate HELOC
Most borrowers think they can only settle on a home equity loan if looking for fixed-rate equity financing. Several lenders now offer HELOCs with fixed interest rates, too. However, you may face extra requirements to lock in a fixed rate. They may include minimum withdrawal and balance requirements. Additionally, fixed-rate options may have a higher initial APR.
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Let us help you. Call or Text Kenna Real Estate Group at 303-955-4220 to get personalized assistance from our expert real estate agents. Find out what your home is worth in today's market.
HELOC Requirements
HELOC requirements usually don't differ from those set for a home equity loan. It would help to have a loan-to-value ratio of at least 15% to 20%, meet a lender's minimum credit score criterion, demonstrate a sufficient income, and have a DTI of no more than 43%. You will also be asked to provide supporting documents and undergo a home appraisal process.
Pros and Cons of Home Equity Lines of Credit
A home equity line of credit is also a double-edged sword. Here are its pros and cons.
Pros:
- You pay interest only on the amount you borrow. This can help you avoid unnecessary debt.
- An initial interest rate will be lower. This way, lenders try to offset the risk of potential APR fluctuation;
- HELOCs have draw periods with interest-only payments;
- Tax deductions. Just like with a home equity loan, a HELOC interest rate can be written off your income taxes if you use the funds to buy, build, or improve your primary or second Home.
Cons:
- An interest rate can change. Most HELOC options have a variable interest rate. This makes your loan unpredictable, as you never know how much you will have to pay;
- Risks of overspending. As a HELOC works similarly to a credit card, it's easy to spend more than you've planned when you always have access to extra funds;
- Your house is pledged. A line of credit will also involve home foreclosure if you default.
Home Equity Loans vs. HELOCs
These two options can be an innovative financial solution, so everything depends on the context. Here's an overview to help you make a decision adjusted to your needs:
| Criteria | Home Equity Loan | HELOC |
| Interest Rates | Fixed interest rates | Variable interest rates, usually lower than fixed ones |
| Repayment Terms | 5 to 30 years. The repayment starts immediately | An up to 10-year draw period and an up to 20-year repayment period |
| Monthly Payments | A borrower makes a fixed monthly payment within the entire loan life | A borrower pays interest only within a draw period and shifts to principal-and-interest payments when the repayment period begins. The amount of payment can change with an APR |
| Closing Costs | May be charged | May be charged |
| Security | The equity you own in your home | The equity you own in your home |
| Loan Amount | Up to 80% of your home's equity | Up to 80% of your Home's equity |
| Whom it suits | Borrowers who need an exact amount for a major expense and want a predictable option | People who are looking for more flexibility and lower initial APRs |
Summing up, home equity loans and HELOCs share similarities, such as closing costs, security, and the amount you can borrow. However, several significant differences exist in the monthly payment system, interest rates, and repayment terms.
A Home Equity Loan or HELOC: Which One to Choose
Both home equity loans and lines of credit can be a powerful tool for financing major expenses. A HELOC may better meet your needs if you need to know the exact sum you need to cover your needs. As you can only use as much as the situation requires, it may help you save money on interest and avoid unnecessary debt.
Alternatives to Home Equity Loans and Lines of Credit
A home equity loan or line of credit is one of many options if you need money for a major purchase or life event. Here are a few alternatives to consider:
- 401(k) loans. A 401(k) loan borrows from your retirement account balance. Although you need to pay interest, it's usually lower than on a traditional loan and will be returned to your account;
- Cash-out refinance. As mentioned, this option involves taking out a new mortgage with a more significant loan amount. After you refinance your primary mortgage, there's money left so that you can use it for various personal needs;
- Reverse mortgage. A reverse mortgage is an option popular with seniors. It allows you to borrow money against your house and wait to pay it back as long as you live there. The repayment is made when a borrower sells the Home or passes away.
FAQ
Which One Can I Get Faster: a Home Equity Loan or a HELOC?
A HELOC is usually more speedy. While it may take 2 to 6 weeks to get a home equity loan, lenders offering lines of credit often claim they can close them within ten business days.
When Is a Home Equity Loan Better Than a HELOC?
A home equity loan is better if you need more predictability and clearly understand how much money you need to reach your financial goal.
Can I Get a Home Equity Loan or HELOC with Bad Credit?
Sure, it's possible. Some lenders accept borrowers with credit scores as low as 600.
What Can I Use Home Equity Loans for?
Lenders usually set no restrictions. You can use your loan proceeds to consolidate debt, overcome unexpected emergencies, cover your high-interest credit card debt, or make home improvements.