If you're a homeowner looking to access the equity in your property, you have two main options: a home equity loan or a home equity line of credit (HELOC). Both products allow you to borrow against the value of your home, but they have different terms, interest rates, and repayment options. Choosing the right option can be a crucial decision, as it can impact your finances for years to come. In this article, we'll compare the key features of home equity loans and HELOCs and help you determine which one is the best fit.
What is a Home Equity Loan?
A home equity loan is a type of loan where you borrow against the equity in your home, using it as collateral. As with most loans, you are applying to take out a fixed amount of money, which you access as a lump sum. You can then use the money to cover large, one-time expenses such as home renovations or major purchases.
Most home equity loans have a fixed interest rate determined at the time of the loan approval, which means your monthly payments will be the same for the lifetime of the loan. Repayment typically occurs in monthly installments with a payback period between 5 and 30 years.
How Home Equity Loans Work
With a home equity loan, you'll get your funds shortly after approval in a lump sum. If additional funds are required, a separate loan application must be submitted, as a home equity loan permits a single withdrawal only.
You will pay back the principal and interest in equal amounts throughout the loan, and in the application, you can apply for the loan term that is appropriate for you. Regardless of the term, repayment usually begins immediately.
Home Equity Loan Fees
Being aware of potential fees associated with home equity loans is also crucial. Since your home is acting as loan collateral, you may need an appraisal to help value the property. In this case, you as the borrower, would be required to cover the appraisal fee. Depending on the lender, you might also encounter closing costs as well. You can ask about these charges beforehand to incorporate them into your decision-making process.
Home Equity Loan Requirements
You can expect the typical requirements for obtaining a home equity loan to include the following:
- Home equity: To qualify, lenders typically require you to own at least 15-20% of your home.
- Credit Score: Fair credit, starting in the low 600s, is usually required to qualify.
- Income: You'll need to demonstrate steady income and employment history.
- Debt-to-income ratio: Lenders determine your ability to repay the loan by comparing total monthly debt payments to your pre-tax income. A good debt-to-income ratio is one where debt is 43% or below.
What is a HELOC?
A HELOC, or home equity line of credit, is a loan that lets you borrow money against the equity you have in your home. Unlike a Home Equity Loan, where you get the funds all at once, a HELOC gets you access to a revolving line of credit. Think of it like a credit card - you can access funds as you need them, up to a certain limit. If you have ongoing expenses, a HELOC may therefore be more appropriate than a Home Equity Loan.
The money can be used for home renovations, debt consolidation, or unexpected expenses. The interest rate on a HELOC is usually variable, meaning it can go up or down over time, and you only pay interest on the amount you borrow, not the entire credit line.
How do Home Equity Lines of Credit Work?
A home equity line of credit offers access to funds via check, online transfer, or credit card soon after approval. While credit is available immediately, you can withdraw at any time.
The repayment structure for a HELOC consists of two phases:
- Borrowing or "draw" period: You can make interest-only or minimum payments and may withdraw funds.
- Repayment period: You can't borrow further and are responsible for paying back the principal plus interest. At that point, the HELOC acts comparably to a loan with set repayment installments.
During the draw period, you can borrow funds as needed and make interest-only payments at a variable rate. Once the borrowing period ends, you must repay the line of credit with regular installments. The principal will be paid back equally over the repayment period, often 10 or 20 years. Remember, HELOCs use a variable interest rate, so your repayment amount can change from month to month.
Some of the costs associated with a HELOC are similar to those of a home equity loan. These include appraisal expenses and closing costs, which can quickly add up to 2-5% of the total loan amount. Other potential expenses unique to a home equity line of credit include annual fees (typically around $50-250), recording fees (around $50) and transaction charges for each time you borrow. You may also face an inactivity fee if you do not use the line of credit for an extended period.
It's best to shop around for lenders who won't charge you all of these fees, or that charge low fees.
Home Equity Line of Credit Requirements
When you apply for a HELOC, lenders analyze your application with the following HELOC requirements in mind:
- Home equity: Similarly to a Home Equity Loan, for a HELOC, lenders will want to see 15-20% equity.
- Credit Score: Lenders will evaluate your credit score for the application, considering a score of 700 or higher as favorable.
- Income: Lenders often review your employment situation to determine if you have a history of steady income and the ability to make the required payments.
- Debt-to-income ratio: Lenders assess your monthly debt costs compared to gross income. Typically, they view a 43% or lower ratio as manageable.
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Pros and Cons of a Home Equity Loan
Weighing the advantages and disadvantages of a home equity loan can help you determine if it is the right financing solution for you.
- Fixed interest rate: The predictability of a fixed interest rate throughout the life of the loan can help make planning easier.
- Lump-sum disbursement: Receiving the total loan amount upfront can help pay for big, one-time expenses and prevent overspending.
- Set repayment terms: A predetermined repayment schedule means installments will be equal over the period.
- Reduced home equity: Borrowing against the value of your home reduces the amount of available equity. This could impact your financial flexibility.
- Risk of foreclosure: Since your home is collateral, failure to make timely payments could compromise your living situation.
- Closing costs and fees: Home equity loans may come with additional fees and expenses, which can add to the overall cost of borrowing.
- Less flexibility: Unlike a HELOC, a home equity loan does not offer the option to borrow funds as needed.
Pros and Cons of a HELOC
Considering the benefits and drawbacks of a HELOC can help you decide if this financing option aligns with your financial needs.
- Flexibility: Money up to your approved credit limit can be accessed anytime, providing financing as needed.
- Interest-only payments: During the draw period, you can make smaller, interest-only payments based on the amount borrowed. This shifts the burden of repayment into future years.
- Reusable credit: As you repay the principal, your available credit replenishes, allowing you to borrow again up to your credit limit.
- Variable interest rate: Your monthly payments will fluctuate based on changing interest rates, which can be difficult to plan around.
- Payment uncertainty: Budgeting can be more complicated with varying payment amounts. This can be more impactful during the repayment period when the principal is due.
- Risk of foreclosure: With your home acting as collateral for your line of credit, late or missing payments could put your home at risk.
- Fees and charges: HELOCs may have annual charges, inactivity costs, transaction fees, and other closing costs.
As a homeowner, you may be eligible to unlock your home's monetary value through a home equity loan or line of credit, converting it into accessible funds. Home equity loans provide a lump-sum disbursement with a fixed interest rate and set repayment terms, making them ideal for sizable one-time expenses. HELOCs offer flexibility through a revolving line of credit and variable interest rates, making them a suitable solution for ongoing needs.
The decision of a home equity loan vs HELOC ultimately depends on your financial situation and specific requirements. One is not inherently better than the other. Instead, it is about choosing the option that is best for you. By exploring the particulars of a home equity loan vs line of credit, you are better equipped to make the right decision when leveraging the equity in your home.
Is it hard to get a home equity loan?
The ability to qualify for a home equity loan depends on multiple factors like how much equity you have in your home, your credit score, your debt-to-income ratio and more.
Does everyone get approved for a home equity loan?
Unfortunately, not everyone who applies will get approved for a home equity loan. Even if you meet your lender's home equity loan requirements, lenders assess each application individually, and there are no guarantees.
Can I open a HELOC and not use it?
You can open a HELOC and not use it immediately. A HELOC functions as a revolving line of credit, allowing you to access money when needed. Some lenders may charge inactivity fees if you do not use the line of credit for an extended period, though.
Are HELOC payments lower than mortgage payments?
HELOC payments can be lower than mortgage payments, especially during the borrowing period when deposits are interest-only. During repayment, installments will include both principal and interest, potentially increasing the monthly amount.