Considering a Second Mortgage? Here’s the Scoop on Home Equity Loans vs. HELOCs
If you’re a homeowner looking to borrow cash against the value of your home, then you’ve probably heard of home equity loans and home equity lines of credit (HELOCS). Unlike personal loans, these types of loans allow you to access credit based on how much equity you have in the home — aka what percentage of your home you actually own. This cash value of your home then acts as leverage to increase your borrowing power.
Depending on how much you still owe on your first mortgage, and the interest rates you qualify for, home equity loans and HELOCs can be a great way to access credit for big things like expensive home repairs, paying tuition fees, or financing unexpected medical bills.
Keep reading for all the details on how you can take advantage of these unique lending scenarios.
What’s a home equity loan?
A home equity loan is a type of second mortgage that allows you to borrow a lump sum of money against the value of your home, which is roughly based on what percentage of your property you actually own.
These loans, which typically come with fixed interest rates, can be used for anything from home improvement projects to helping pay for college tuition. As a type of installment loan, home equity loans are typically repaid during established monthly payment cycles. Since home equity loans are a type of secured loan that uses your home as collateral, they’re usually reserved for important, big-ticket items that either add value to your home or would otherwise be unaffordable.
For example, while replacing the roof on your home or going back to school to earn a degree might all be good reasons to borrow against the value of your home, a vacation to the Bahamas probably isn't. Because your home will essentially be used as collateral against the loan, you risk foreclosure if you become unable to repay your home equity loan balance. For this reason, people tend to take out home equity loans only for essential expenses, rather than frivolous ones.
When it comes to the amount you’re able to borrow for a home equity loan, that number will be at least partially determined by your loan-to-value ratio (LTV) — which divides your current loan balance by the current appraised value of your home. Lenders typically like to see an LTV of 80% or less, although they will also consider other factors like your credit score, income, and any other outstanding debts you may have.
How to get a home equity loan
In order to apply for a home equity loan, you’ll first need to come up with an amount you’d like to borrow. Again, you may want to consider things like your LTV before just coming up with a random number, since this will help you understand if your home could even be used as collateral for the amount you need to borrow.
Besides coming up with a loan amount, you should also be prepared to provide additional financial information like your employment status and proof of income, as well as the details on your mortgage and property value. It’s also likely that a lender will want to run a credit check, which may result in a hard pull on your credit score. Having these things in mind before approaching a lender can be hugely helpful, both in setting you up for borrowing success, as well as being prepared for the various steps involved in the loan approval process.
Finally, don’t forget to shop around before signing up with a lender. Be sure to look into various loan closing costs, as well as loan terms (like the terms of your loan disbursement) before finalizing anything. It’s also a good idea to cross-reference your rate loan offerings to be sure you’re not missing out on lower interest rates with a different lender.
Who a home equity loan is good for
A home equity loan would be best for someone who has significant equity in their home (ie. owns 20% of the home or more) and who has a big project or goal in mind. Again, because this type of loan is backed by your home, you’ll want to be sure you’re borrowing it for a good reason.
If you find yourself in need of extra liquidity for something small, or if you don’t own enough of a stake in your home to be eligible, then a personal loan might be better for your needs.
What’s a HELOC?
Another borrowing option for homeowners with a significant ownership stake in their property is something called a home equity line of credit (HELOC). Unlike home equity loans, which are fixed sum loans typically offered with fixed interest rates, HELOCs are revolving lines of credit with variable interest rates. Just like any other line of credit, you’ll only need to pay off what you spend within your credit limit.
Say for example you’re approved for a $20k line of credit but only plan to use $10K. Your monthly payments will only reflect the amount you spend, which in this scenario would only be half of your available credit.
Another thing to keep in mind about HELOCs is that they typically have a set draw period of 10 years. Within that borrowing period you can spend any amount of your credit limit, even spending and repaying it several times over. However, once the borrowing period is done, you’ll switch to a repayment period where you’ll be responsible for repaying the remaining balance of your loan over the next 10 to 20 years.
If you find that you need more time to withdraw funds, then you might be able to refinance your HELOC. Refinancing will change the terms of your loan, and keep in mind that just like home equity loans, HELOCs use the value of your home as collateral— meaning, you’ll want to spend (and repay) these loans responsibly.
How to get a HELOC
The process of applying to a HELOC is similar to applying for a home equity loan. You’ll first need to decide how much credit you’d like to borrow, then prepare your finances for the loan application process.
When it comes to figuring out how much of a HELOC you can afford, it’s helpful to use something called your combined loan-to-value ratio (CLTV). You can determine this number by adding your desired line of credit to your existing mortgage, then dividing that sum by the current appraised value of your loan. Most lenders will require your CLTV to be 85% or lower in order to approve your HELOC application.
If your CLTV is higher than 85%, you might consider either requesting a smaller line of credit, paying down more of your first mortgage, or waiting to see if the value of your property increases.
Another reason to be sure your finances are in order before applying for a HELOC is that it will help you qualify for the best interest rates. Prime rates, or the rate at which banks offer credit to their preferred customers, are only available to those with good credit scores and in good financial standing. If your CLTV is too high, or your credit score too low, then you might be better off improving your overall financial profile before submitting an application.
Who a HELOC is good for
HELOCs are a great option for anyone with substantial equity in their home who needs more flexibility in their borrowing capabilities. This might work well for someone who isn’t quite sure how much money they want to borrow or for someone who may need to borrow several sums over a period of years.
Keep in mind that although HELOCs come with more flexibility, they can also end up costing you more in the long run. Because HELOCs generally have variable interest rates, you might end up paying a significant amount in interest payments during your repayment period. Be sure to look into whether or not your interest payments qualify as tax-deductible, since this may be another way for you to save money on the overall cost of your loan.
Home equity loan vs. HELOC
When deciding which method of borrowing is best for your needs, it’s important to take a few things into consideration. The first is which kind of sum you’d like to borrow. Maybe you know in advance the exact amount of money you need, or maybe you’re not exactly sure. While home equity loans are typically one borrowed sum, HELOCs offer more flexibility and enable you to borrow various amounts of money (within your credit limit) over a multi-year period.
The other thing to consider with these two types of borrowing is the difference in their repayment methods. While repayment periods for home equity loans usually start not long after the loan is borrowed (with fixed interest rates), HELOCs operate on a delayed repayment schedule (with variable interest rates). Borrowers who choose to get a HELOC will first enter into a borrowing period (usually of 10 years) then transition into a repayment period thereafter.
The bottom line
Home equity loans and HELOCs are a great way to borrow large amounts of money against the accumulated value of your property. If you’re a homeowner in need of a large sum for a home improvement project or to help pay for school or medical bills, then one of these loans might just work well for you. If you do end up taking out a home equity loan or a HELOC, just be sure to do so responsibly. Remember, these loans ultimately use your home as collateral and making sure you can repay them on time should be your number one priority as a homeowner.