Whether you've built equity by paying down your mortgage or having your home's value rise over time, you could eventually take advantage of the money through a home equity line of credit (HELOC) or home equity loan. Like mortgages, these financial products get tied to your property and have qualifications you'll have to meet, but they differ in that you can use funds for various purposes. HELOCs and home equity loans also work differently and have some unique pros and cons. Take a look at what you should know about each type of loan as a means of leveraging your home's equity.
Understanding Your Home's Equity
You can think of your home's equity as the value left over after you take into account outstanding loans you have on the property. If you just have a mortgage on the property, then your home equity is simply the current market value minus the remaining loan balance of the mortgage. While you can simply find your remaining mortgage balance on the most recent statement, determining your home's market value can require an appraisal or research as various factors influence it, and the value usually changes over a period of time.
For example, consider that your property has $150,000 left on the mortgage, and an appraisal determines that the current value of your home is $325,000. This leaves you with $175,000 in equity as a loan amount that you might tap into if you qualify for home equity financing. However, lenders will set maximums that can prevent you from borrowing against the full amount of equity.
If you're wondering how your equity plays a role in what you can borrow through a HELOC or home equity loan, it helps to look at your property's loan-to-value (LTV) ratio since lenders use that calculation in their decision to extend these types of credit. You simply take your current mortgage balance and divide it by the current appraised value. Using the previous example with a mortgage balance of $150,000 and a value of $325,000, the LTV would be around 0.46, or 46 percent.
Looking at Home Equity Loans
Home equity loans provide homeowners with the opportunity to get a lump-sum amount of borrowed money that typically features a fixed rate of interest for some predictability with payments. Once you take out this loan, you'll pay the principal and interest on the amount of money you borrow over anywhere from 5 to 30 years, and you typically have the same monthly payment over the entire course of the loan. You can use the funds for a variety of expenses such as emergencies, medical bills, higher education costs, business startup, home improvement projects or even debt consolidation.
Like your mortgage, a home equity loan uses your home as collateral. This means that foreclosure could happen if you default on the home equity loan, so the decision to take this loan out will require careful consideration of your finances. The home equity loan can also have some associated costs including an origination fee and closing costs, alongside any fees you can experience if you pay your loan off early or make a payment late.
Exploring Home Equity Lines of Credit
A HELOC comes with more flexibility when taking advantage of your home's equity since you have more control over how and when you use borrowed funds. Rather than receiving a lump sum once you've closed on the loan, you receive access to an open line of credit up to a maximum amount, and you can eventually draw as little or as much as you need during the draw period that the lender sets. For example, you might get five or 10 years to borrow money with a HELOC, and you have to just make interest-only payments during that time.
As soon as the HELOC draw period ends, you will no longer have access to the money unless your lender gives you an extension, and you then make principal and interest payments for the amount used. Unlike with a home equity loan, HELOCs usually come with variable interest rates, so your monthly payment may vary as rates change. The payback period can extend as much as 20 to 25 years – depending on the length of the draw period – if you have a 30-year HELOC. Defaulting on a HELOC can cause you to lose your home like with a home equity loan or mortgage.
This home equity borrowing option has similarities to regular home equity loans when it comes to costs and uses. You might pay origination fees and closing costs, though some lenders waive the closing costs for this type of financial product. You can withdraw money from the HELOC for many uses, whether you want to pay off some other expense, build onto your property or even purchase a second home.
Read More: What is a Home Equity Line of Credit?
Home Equity Loan Pros and Cons
Taking out a home equity loan can seem like a more appealing option than using a credit card or personal loan for expenses since you can benefit from low interest rates. As long as you've had time to build up substantial equity in your home, you can also get access to a large sum of funds with this option and benefit from a long repayment period if you need it. Your payments are predictable thanks to a fixed interest rate, you have a lot of control over how you use the money and you can even get tax benefits when you use the money for home improvements.
However, you should be aware that taking out a home equity loan can end up being costly since getting a lump sum makes it tempting to spend and opting for a long loan term with lower payments means that you pay more in interest for the benefit. You can especially run into issues with foreclosure if you fall behind on your payments for such a loan. You can also run into some barriers when getting a home equity loan since you'll need good credit, a suitable percentage of equity and funds reserved for any closing costs.
HELOC Pros and Cons
When compared to a home equity loan, a HELOC offers an advantage in flexibility with the draw period that can help you avoid borrowing more money than absolutely necessary and ultimately help you save in interest. Payback during the draw period can be easier due to interest-only payments, and you can enjoy low interest rates like with a home equity loan. Depending on the lender, you might avoid closing costs with a HELOC and get the opportunity to opt for a fixed interest rate if you'd rather have more predictable payments. You may also get tax benefits for certain home-related uses.
On the other hand, the ability to withdraw money as you please and make interest-only payments during that time can tempt you to borrow more than you should. Once you move to the full repayment period, the larger principal and interest payment can strain your budget if you don't borrow wisely and plan ahead. Since these lines of credit usually have adjustable rates, you face the risk of interest rate increases, and your home is at risk if you can't make payments since this is a secured loan. You also face qualifications and can pay fees both when you open the HELOC and during its use and repayment.
Read More: How to Use a HELOC for a Down Payment
Choosing How to Borrow From Equity
When deciding between taking out a home equity loan or HELOC, it helps to consider whether you know how much money you need to borrow right now or if you need flexibility with the amount. If you have a set amount in mind and prefer to make predictable payments, then a regular home equity loan can be a good fit for your situation. On the other hand, a flexible HELOC can appeal to you if you plan to need money at different intervals – such as for various home renovations – and if you'd prefer lower interest-only payments while you have access to that credit line.
If neither of these options seems right for you, you might consider the alternative of doing a cash-out refinance. Rocket Mortgage explains that this option involves taking out a new mortgage that will be used to pay off the existing home loan as well as offer you extra cash based on a percentage of the equity that you have. Although the application process is more extensive and the closing costs can run higher, you can benefit from low interest rates with the cash-out refinance option. A lender can provide advice on all your options based on your property and finances.
Knowing Whether You Qualify
Since both HELOCs and home equity loans have several requirements, you should take some steps to determine whether you qualify for these home equity financing options. Here are a few factors to consider:
- Your current home equity: Since lenders will likely want you to have a minimum of 15 to 20 percent equity in your home, you should get your current mortgage balance and an estimate of the current value of your home to see if you meet this threshold. You can plug the two numbers – along with any second mortgage you already have on the home – into a home equity calculator. This tool will show you the equity available depending on various loan-to-value ratios. Keep in mind that lenders often limit the amount you can borrow to no more than 95 percent LTV.
- Your credit: For the highest likelihood of getting home equity financing and qualifying for good rates, it helps to have a credit score of at least 700, although it's still possible if your score is 620 or higher. You'll also want to make sure your payment history reflects timely payments and no recent events like bankruptcies or collections accounts.
- Your debts and income: Since a HELOC or home equity loan will add another payment to your obligations, lenders will want to make sure you can afford it alongside the mortgage and other debts. This means analyzing all your debt payments and income to determine a debt-to-income (DTI) ratio. Depending on the lender, the DTI ratio may be as low as 36 percent or as high as 50 percent. Wells Fargo has a DTI ratio calculator you can use to determine this figure quickly. Keep in mind lenders will also assess the stability of your income.
Read More: What Documentation Do You Need for a HELOC?
Getting Home Equity Financing
For your convenience, you can go online and check with various lenders to get a prequalification for a HELOC or home equity loan and learn about specific limits and requirements. As you move through the official application process, you'll notice some similarities to applying for a mortgage as you'll submit documents to verify your financial information, sign plenty of papers and have an appraisal to get your home's current value. You'll also have a closing meeting where you sign off on the loan or line of credit, and you can soon expect access to the home equity financing.
- Federal Trade Commission: Home Equity Loans and Credit Lines
- Investors Bank: Find Out How Much You May Be Able To Borrow
- Consumer Financial Protection Bureau: My Lender Offered Me a Home Equity Line of Credit (HELOC). What Is a HELOC?
- IRS: Interest on Home Equity Loans Often Still Deductible Under New Law
- Consumer Financial Protection Bureau: What Is the Difference Between a Home Equity Loan and a Home Equity Line of Credit?
- Consumer Financial Protection Bureau: What Is a Home Equity Loan?
- Georgia Department of Banking and Finance: Home Equity Loans and Lines of Credit
- MyCreditUnion.gov: Home Equity Loans & Lines of Credit
- Rocket Mortgage: Cash-Out Refinance: Rates And Guide For Homeowners
- Bankrate: Requirements for a Home Equity Loan or HELOC in 2021
- Santander Bank: 9 Steps of the HELOC Application Process
- Consumer Financial Protection Bureau: What Is a Loan-To-Value Ratio and How Does It Relate To My Costs?
- Rocket Mortgage: Home Equity Loans: A Complete Guide
- Wells Fargo: Debt-to-Income Ratio Calculator
Ashley Donohoe has written about business and technology topics since 2010. Having a Master of Business Administration degree, bookkeeping certification and experience running a small business and doing tax returns, she is knowledgeable about the tax issues individuals and businesses face. Other places featuring her business writing include Zacks, JobHero, LoveToKnow, Bizfluent, Chron and Study.com.