Homeowner equity is near all-time highs right now as home prices have skyrocketed over the past few years. And while mortgage rates have been creeping up, they are still near low, historically speaking, making it a great time to tap that home equity for other financial needs. If you are considering using some of your equity through a second mortgage, you may be wondering whether to take out a home equity loan or a home equity line of credit (HELOC.) Here are the differences that may help you decide.
General Equity Loans Similarities
Both types of equity loans are second mortgages, as you already have a primary mortgage. They are both tied to your home as collateral. In the case that you default on your loans and your home goes into foreclosure, the first mortgage gets priority on the profits of the home sale, and whatever is left over after the first mortgage is repaid goes to the second mortgage. For this reason, second mortgages are riskier than primary home loans and the interest rates are slightly higher on home equity loans to reflect that possibility. However, both home equity loans and lines of credit usually have lower interest rates than those of credit cards and personal loans.
For any type of home equity loan, borrowers must have a substantial amount of existing equity in their properties. In general, most lenders like to see a minimum of 15% to 20%. The amount of money homeowners can pull out is calculated by subtracting the remaining mortgage balance from 85% of the home’s current value. For example, if your home is now worth $400,000, and you still owe $300,000 on your home loan, you could pull up to $40,000 out of your equity.
With both home equity loans and HELOCs, you can use the money you obtain for any purpose; there are no restrictions on its use.
And for both types, you’ll need to qualify for the loan. This typically requires a decent credit score, adequate income, and a lower debt-to-income ratio.
Now here’s how home equity loans and lines of credit differ:
Home Equity Loans
These work very much like a primary mortgage, as they usually have fixed rates and an amortized repayment schedule, making them very predictable. Once you apply and are approved, you will get the equity as a lump sum to use for home renovations, consolidating debt, or any other financial need you have.
You will start making repayments on the home equity loan immediately and if you end up needing more funding you’ll have to first pay off the second mortgage before tapping more of your equity.
Home Equity Line of Credit (HELOC)
A HELOC functions more like a credit card that is tied to your home. After you apply and are approved, your lender will give you a spending limit and a set period for borrowing money. This provides a little more flexibility over a home equity loan as you can pull out as little or as much as you need in a given period. In theory, this means you wouldn’t end up paying interest on funds you don’t end up using. It also means you do not have to know the exact amount you need before applying for the loan, as you can borrow any amount up to your credit limit. The interest rate is typically variable though, making it more difficult to foresee just how much interest you’ll end up paying.
You will start repaying the loan in full and cannot pull any more money out after the borrowing period ends, although you will need to make a minimum monthly payment during the draw period.
Both home equity loans and HELOCs can provide an excellent source of funding for important financial goals at interest rates lower than most other loans. Which one makes the most sense for you is a matter of how sure you are of your exact needs and whether you are comfortable with a changing interest rate.
If you're interested in a Home Equity Loan or a Home Equity Line of Credit please give us a call today!
These materials are not from HUD or FHA and were not approved by HUD or a government agency. We do not provide tax, legal, or accounting advice