When you’ve lived in your home for a while, you build up a little equity. If you sell your house, having equity means you’ll make more on the sale than you owe on the loan you took out to buy it. But you can access this equity even without selling through two vehicles: a home equity loan and a home equity line of credit
What Is Equity?
When you bought your home, you probably took out a mortgage loan to buy it. Each month, when you pay your mortgage payment, you chisel a little of that loan amount away, reducing the overall amount you owe. At the same time, the value of your home may be increasing, assuming the economy in your area is strong and inflation has an impact on prices.
The market value of your home, combined with the progress you’ve made in paying off your loan, can give you access to funds. That equity makes your home an asset that a lender can use as collateral. You can take a loan against that equity, or you can instead open a home equity line of credit (HELOC).
What Is a HELOC?
With a home equity loan, you get a straight loan based on the equity in your home. You’re typically limited to only 85 percent of the equity in your home. As with any other loan, you’re expected to make payments with interest.
A home equity line of credit, on the other hand, is a revolving line of credit similar to a credit card. You’re given a limit that you can borrow against as you need it. If you have a $10,000 line of credit, you can take a few hundred dollars out here and there, then put the money back when you have some extra cash to spare.
Read More: Home Equity Line of Credit: What You Need to Know
Typical Home Equity Loan Amounts
To determine the equity in your home, a lender looks at the market value of your home and subtracts the remaining principal on your mortgage balance. Your home equity line of credit will be up to 85 percent of that amount, but that doesn’t mean you’ll be approved for that. The lender looks at the usual criteria, including your debt-to-income ratio and credit score, to determine the credit limit.
If you owe $300,000 on your house but it’s worth $350,000, that gives lenders $50,000 to work with. If you get the full 85 percent, you’d have a $42,500 line of credit. Once finalized, the money is available to you for a period known as a “draw period,” which is usually 10 years.
Getting a Home Equity Loan
You can get a HELOC at any lender where you’d get a mortgage loan or refinance an existing mortgage. But you aren’t obligated to use the lender that has your loan. It may be easier to keep everything in the same place, but it’s important to compare offers to make sure you’re getting the best deal.
As you’re pricing HELOC lenders, consider traditional and online lenders, as well as credit unions and small, local banks. Look at the interest rates and the draw period being offered. Even a small savings on interest rates can save you money if you’re paying back a draw of $10,000 or so.
Why a HELOC?
Home equity lines of credit can be great alternatives to a personal loan or cash-out refinance. Instead of taking money out in a lump sum, you only borrow what you need as you need it. A home equity line of credit (HELOC) usually has a lower interest rate than a credit card, so you can save money by relying on it instead of plastic.
You can use your HELOC for a variety of purposes. You may even choose to have it on standby in case you ever have an emergency. Homeowners use HELOCs to fund home improvement projects, consolidate costlier loans or help pay for a child’s college education, just to name a few uses.
Terms of Home Equity Loans
There are two phases at play in the terms for a home equity line of credit: the draw period and the repayment period. With the draw period, which is usually around 10 years, you can take money out of the loan and use it. During the draw period, you’re only required to pay interest on the money you take out. But unless you replenish the money you’re borrowing, it counts against the credit limit.
The repayment period kicks in after that draw period ends. At this point, your loan is assigned a payment schedule with the amount you borrowed divided into monthly payments with interest. You cannot take money out during the repayment period unless you refinance the HELOC.
Home Equity Loan Interest Rates
One thing that often comes up in FAQs concerning HELOCs is how interest is charged. There’s a reason for that. You’re paying interest on the money from the time you take the first draw, so it’s important to know what you’ll pay.
Interest rates for HELOCs are usually charged a variable interest rate, which means the rate goes up and down with the economy. Your lender faces regulatory requirements in setting those rates. They must be based on a publicly available interest rate, and there has to be a cap on the amount that can be charged.
With some lenders, you can convert your HELOC to a fixed interest rate at some point. This could help save you some money if the interest rate increases after you make the switch. You can also find lenders that offer an introductory rate that gives you a break on interest. For instance, you may enjoy six months with a locked-in lower interest rate before it kicks into variable mode.
Home Equity Loan Closing Costs
You won’t skip closing costs by going with a HELOC over a home equity loan, but it’s often cheaper. The lender will probably still want to do a home appraisal to check the market value of your home, as well as the usual processing fees.
The best time to think about these fees is while you’re still shopping around. If you find one lender’s costs are lower than another, you can weigh that against any interest savings. You may also be able to negotiate those costs if you find a good interest rate or you have a specific lender you want to use.
Are HELOCs a Good Idea?
Overall, there’s no harm in having a home equity line of credit that you can access if you need it. However, before you actually use it, you should consider all the options. You’ll get a lower interest rate than you would with a credit card and some personal loans, but if you’re using it to fund college education or luxury vacations, it might not be the best idea.
The bad thing about HELOCs is that they use the available equity in the value of your home as collateral. That means if your finances get out of control and you can’t repay the loan, you could put your home in jeopardy. Since you won’t have to start repaying the loan until after the draw period ends, years later, you might not realize now what your financial situation will be a few years down the road.
Read More: How to Use a HELOC for a Down Payment
Are HELOCs Hard to Get?
If you have decent equity in your home, you should be able to get a home equity line of credit fairly easily. Your home is used as collateral, so the lender isn’t taking as big a risk as it would with a personal loan or credit card. That collateral also helps you get a lower interest rate even if your credit score and income levels aren’t what they should be.
But make no mistake: You still need to go through the application and approval process. Lenders want to take a look at your credit score and debt-to-income ratio before giving you a line of credit to use.
The minimum credit score varies by lender, but typically, you need at least a credit score of 620 for a home equity loan or home equity line of credit. Your debt will probably also need to be no more than 43 percent of your income. Before you start shopping around for a loan, check to make sure these two things are in good shape.
Home Equity Loans and Taxes
One good thing about HELOCs and home equity loans is that the interest you pay can be tax deductible as long as you use the loan solely to buy, build or substantially improve your home. The loan you’re taking also has to be against the equity in your main home, so a vacation home won’t qualify for this tax break.
There’s also a limit on how much of your home interest is tax deductible. A married couple can only claim interest on mortgages and home equity loans for up to $750,000 of debt, or $375,000 if you’re filing separately. If the debt was taken out before Dec. 16, 2017, you can claim up to $1,000,000, or $500,000 separately.
Alternatives to Home Equity Loans
There are some good alternatives to home equity loans. Which option is best for you depends on the purpose of your loan.
Here are some to consider:
- Home equity loan: This might be better if you have a specific amount in mind. You can take the full amount, then start paying back the amount immediately.
- Cash-out refinance: With this option, you refinance your home, but you get a portion of your equity as cash. This lets you continue to pay your mortgage while also having the funds you need now.
- Refinance: If you’ve built significant equity, refinancing could be a good alternative. You can lower your monthly payment so that you have extra money in the bank each month. However, if you choose this route, look out for pricey closing costs that could cost you more than you’d gain in the long run.
- Personal loan: If you qualify, a personal loan should give you the money you need. Although the interest rate may be higher, you won’t be putting your home up as equity, so you’ll have less at stake if for some reason you can’t pay the funds back.
- Credit cards: These are better for small, emergency purchases. If you can get a low introductory rate and pay the balance off quickly, you could end up with a better deal than you’d get with a HELOC.
Building Equity in Your Home
Before you can take a loan against the equity in your home, you need to first have equity in it. Look at your loan balance and compare it to the value of your home. If the market value isn’t much more than what you owe, chances are you won’t be approved for a home equity loan or line of credit.
There are two ways to remedy the situation: increase your home’s value or decrease the loan amount. By paying a little extra on your mortgage each month, you can start to chip away at that balance. But you can also make small changes that increase your home’s value. Another option is simply to remain in the home and wait until you owe less and the place is worth more.
Getting a HELOC Approved
As with any loan, you need to provide some documentation before you’ll be approved for a HELOC. There is an application, of course, but you also need to provide information on your employer. Your lender may call to verify your employment, as well.
Even with a strong credit score and a low debt-to-income ratio, a lender will still want income verification, so you need to provide pay stubs or a W-2 to show that you have money coming in. The lender merely wants to reduce its risk by making sure you’ll pay your bill each month when the time comes.
Read More: What Is LTV HELOC?
A home equity line of credit is a great way to get the money you need for home improvements or other essential experiences. But it’s important to only use the funds if necessary, since your home will be used as collateral. If you ever get in a situation where you can’t repay the amount, make sure you talk to the lender to work something out.
Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.