HELOC and Home Equity Loan
What are they, and which one is best for you?
A new kitchen with all the latest gadgets would be nice, wouldn’t it? Maybe now is the time for that remodeling project you’ve been dreaming about.
Perhaps your son or daughter is getting married, and you’re paying for the wedding. Or maybe you need a substantial lump sum of money for something else.
If you’re a homeowner who has been making mortgage payments for the past few years, then you likely have access to the funds to help pay for those major investments. We’re talking about a home equity line of credit (HELOC) or a home equity loan. Both are popular options as a convenient and often swift way to pay for large expenses.
So, how do they work?
The equity in your home is the difference between the current market value of your home and how much you owe on your mortgage. Subtract how much you owe from the value and the difference is your equity. Lenders allow you to borrow against this difference.
“You can borrow against the equity in your home using your home as the collateral for the money you borrow,” says Alan LaFollette, Managing Director at First National Bank of Omaha.
That’s what makes HELOCs and home equity loans different from a personal loan: Your house is the collateral. Which means the equity increases both as you pay down your mortgage and when the home’s value rises.
Similar, but different
HELOCs and home equity loans are also called second mortgages. But both loans are usually for shorter terms – for example, 10 or 15 years – compared to a first mortgage, which is typically for 30 years.
Home equity loans normally come with fixed rates, whereas a HELOC traditionally comes with adjustable rates.
“A HELOC works more like a credit card, with a revolving line of credit,” says LaFollette. “You are given a line of credit that is available for you to borrow from for a set amount of time, which can be up to 10 years. You can withdraw money as you need it using a check or a debit card attached to that account.” (Note: Not all states allow use of a debit card to withdraw from a HELOC. Check with your bank to conform whether or not this is permitted.)
On the other hand, a home equity loan is a term loan in which you borrow a one-time lump sum. Then you pay back that lump sum over a pre-determined amount of time at a fixed interest rate with the same recurring monthly payments.
A big advantage
Obtaining a HELOC is a good option if you’re thinking about a facelift for an outdated kitchen, a bathroom remodel or an addition to your home. Sometimes major home improvements, such as a bathroom remodel, can result in an increase in your home’s value.
Whether a HELOC is for a home improvement or a big event in your life like a wedding or college education expenses, a HELOC or home equity loan might still be the better choice for borrowing money. Credit limits are usually higher and interest rates are typically lower when compared to a high-interest rate credit card.
How much can I borrow?
This depends on a few things; most importantly, the value of your home. Lenders generally cap the amount you can borrow at 80-85% of the equity in your home. 
Nerdwallet also says you typically need to have a credit score of at least 620 and the home needs to be valued at 10-20% more than what you owe on the mortgage. Income and debt-to-income ratios are also factors. 
Consider the following example when determining how much you can borrow using a loan-to-value calculation:
You have a house that has a current market value of $250,000 with a balance of $150,000 on the mortgage. Your lender allows you to access up to 80% of the home’s loan-to-value equity.
- $250,000 x 80% = $200,000
- $200,000 - $150,000 = $50,000
- $50,000 is how large your line of credit could be with a HELOC or how much you can borrow for a home equity loan.
That means you can make some major renovations on your home, host a very nice wedding for your son or daughter, or use that money for other large investments, such as paying off substantial credit card debt or helping pay for your child’s higher education costs.
Things to consider
While there are several advantages to taking out a HELOC or a home equity loan, there are also some important elements to consider:
- If you borrow money against the equity in your home and home prices decrease before you are able to pay it off, you could end up owing more than your home is worth. This is known as being underwater with your mortgage, a dilemma that was prevalent during the housing crash of 2008, when borrowers were stuck in homes they could not sell because their values sank.
- And remember, if you can no longer make payments on the loan, then you risk your house going into foreclosure because your home is the collateral on the loan.
Of course, before you decide either way, it’s smart to ask your lender questions, like:
- What are the interest rates?
- If interest rates go up or down, how much will my payments be?
- How long is the term of my home equity loan?
- How long do I have to pay it off?
- Is my line of credit renewable when the loan expires?
In addition to speaking with your lender, it’s wise to consult a tax advisor or financial planner who can help explore the best options for you.
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