Throughout your life, there may be times when you need a quick injection of cash. Whether that’s for home renovations, college tuition, debt consolidation, or a major life event, having funds available as soon as possible might quickly become important.
If you’re a homeowner, you may be able to tap into the equity you’ve built up in your property to help finance this. Two of the most popular ways to do this are a home equity loan or a home equity line of credit, also known as a HELOC.
What is home equity?
Before getting into the specifics of these loan types, it’s important to understand what home equity actually is. Your home equity is the difference between what the property is currently worth and how much you still owe on your mortgage. In other words, this is the amount of your home that you technically “own” outright.
For example, if your property was valued at $500,000 and you owed $200,000 on your mortgage, your home equity would be $300,000.
Having equity in your home is important because it can be leveraged when you need access to cash. How this works in real terms is you turning a portion of your home’s value into tangible cash that you can use when you need it.
What is a home equity loan?
A home equity loan is a specific type of home loan, almost like a second mortgage, that allows you to borrow a lump sum in cash while borrowing against your home’s equity. You’ll receive the money all at once and repay the loan amount in fixed monthly installments over a set term, in a similar way to a traditional mortgage. These loans typically range anywhere from five to 30 years.
How does a home equity loan work?
When you’re thinking about taking out a home equity loan, there are several important pieces of information that your lender will need to know. First is the current value of your home, typically appraised by a third-party vendor. They’ll also need to know what your current mortgage situation is to determine your overall equity.
From there, the lender will also need to know your credit score, along with your income and debt-to-income ratio. Generally, most lenders will allow you to borrow up to 85% of your home’s appraised value, minus the balance of your mortgage.
For instance, a home worth $400,000 with a $250,000 mortgage balance would be eligible for $90,000 as a maximum loan amount.
Once the home equity loan has been dispersed, monthly payments covering both the principal and interest will begin. These are typically fixed loan payments, so won’t change over the lifetime of the loan.
What do you need to apply for a home equity loan?
For your best chances of being approved for a home equity loan, you’ll need to provide proof of income to your prospective lender. This could be pay stubs from your current job or a recent tax return. You’ll also need to have a strong credit score, likely over 620 but for some lenders this may be higher.
You should also have a debt-to-income ratio below 43%, along with around 15-20% equity in your home when you apply for your loan. However, every lender is different so check their requirements before you submit your application.
Pros and cons of a home equity loan
One of the biggest benefits of a home equity loan is that the monthly payments you make are fixed, so you’ll know exactly how much you’ll be paying each month until the loan is paid in full. You’ll also receive a lump sum payment, so this is best when you need to cover a large expense like a home renovation or medical bills. Because home equity loans are secure, rates are also usually much lower than any other type of personal loan.
There are some cons to these loans, though. They’re less flexible than other loans you might be eligible for, as you can’t increase the loan amount without refinancing again. You may also have closing fees as an upfront cost like with your original mortgage. There’s also the potential risk when using your home for security. If you default on the loan, your home could be foreclosed on.
What is a HELOC?
Unlike a home equity loan, a home equity line of credit is a revolving line of credit that’s secured by the equity in your home. You can borrow as needed up to a fixed amount, rather than receiving a lump sum payment. Similar to a credit card, you can borrow up to the maximum limit and will pay off what you borrow.
How does a HELOC work?
There are typically two phases of a HELOC. The draw period usually lasts around five to 10 years, where you can borrow as much as you need against your line of credit. Most HELOCs only require you to pay the interest during this time, but you can also pay the principle if you choose to.
After this, there is often a 10 to 20 year period of repayment, where you can no longer borrow funds against that specific line of credit and you’ll need to repay the balance of both interest and credit.
Like a credit card, a HELOC has a variable interest rate, which means that it can fluctuate with market conditions. This can make your monthly payments less predictable, especially if interest rates rise.
Pros and cons of a HELOC
HELOCs are typically best for borrowers who need flexibility in the amount they want to borrow, which can be helpful for ongoing projects with varying costs. If you need revolving access to this money, a HELOC can be beneficial as you’ll have access to the full loan amount again during the draw period once you’ve paid off the principal.
However, the variable interest rates of HELOCs can be difficult to budget for. There’s also potential shock payment once your draw period ends and you need to pay both principal and interest. Finally, the temptation to overspend is always there, as having easy access to funds may mean you could take on more debt than you can realistically manage.
Home equity loans vs. home equity lines of credit
There are pros and cons to both loan options, so it’s important to understand the key differences between a home equity loan and a HELOC.
|
Feature |
Home Equity Loan |
HELOC |
|
Payout |
Lump sum |
Borrow as needed |
|
Interest Rate |
Fixed |
Variable |
|
Repayment |
Starts immediately |
Interest-only draw period, full repayment later |
|
Monthly Payments |
Fixed |
Variable |
|
Best For |
One-off expenses |
Ongoing or unpredictable expenses |
When a home equity loan is a better fit than a HELOC
Generally, a home equity loan is a better choice if you’re looking for a stable, fixed monthly payment on your loan. It’s also a better option if you have a specific, one-time expense that you’re looking to cover like a home renovation or a wedding.
If you want to lock in a good interest rate, a home equity loan will always be a better choice than a HELOC, particularly when interest rates are rising. There’s a good level of predictability with a home equity loan, so you won’t have any surprises in your monthly budget.
Fund your big plans with a home equity loan
Working with a home equity loan specialist in your community like Union Bank means you’ll benefit from working with experts who can guide you through the application process and ensure a smooth experience from application to funding. We’re here to answer your questions and offer competitive home equity loan rates that help you achieve your financial goals.
Contact us today to get started on your home equity loan application.