What are Home Equity Lines of Credit (HELOC) and Home Equity Loans?
If you are new to the world of Home Equity Loans and HELOCs, learn how these loans work and how you may be able to use them to your advantage.
How Do Home Equity Loans Work?
Home Equity Loans, or Home Equity Lines of Credit (HELOCs), can be used to pay for a wide variety of items and expenses. When you take out one of these loans or lines of credit, you are using the available equity of your home as collateral.
Standard home equity loans come with a fixed interest rate, while HELOCs offer standard or variable rate loans. Plan options may vary per lender. Typically, variable rate HELOCS can have a lower initial interest rate but can vary during the life of the loan. This means that the corresponding periodic rate and minimum payment can change as a result. Variable rate HELOCs can help you save on interest if you plan on repaying the bulk of what you owe when the interest rate is at its lowest. If you need more time to pay off the loan, a standard rate Home Equity loan or HELOC may be a better choice.
What Are Home Equity Loans?
Home equity loans are typically used by homeowners looking to make repairs on their home or other large purchases. A home equity loan will become a second mortgage on your home if you currently have a mortgage, which can come with risks.
If you qualify, the bank or credit union will issue the lump sum, minus any taxes and fees. You will then have to make fixed monthly payments until you pay off the loan, including interest. Additional payments made will save money on interest.
When to Use Home Equity Loans
You might think of taking out a home equity loan when starting a small business, going back to school, buying a car or making repairs on your home. They are usually reserved for big, one-time purchases. If you use the loan to make repairs on your home, they may be tax-deductible.
How to Qualify
Depending on the lender, you may need a certain amount of equity in your home; 20% is the typical minimum. 20% equity means that you have paid down 20% of the principal balance on your mortgage. If you own the home free and clear, you effectively have 100% equity. Your credit score, as well as other factors such as debt-to-income ratio, can affect the interest rate and approval odds.
What Are Home Equity Lines of Credit (HELOCs)?
HELOCs work similarly to credit cards, except they are secured debt, which means your home will be used as collateral. HELOCs are not to be confused with home equity loans. Instead of receiving a lump sum, the bank or credit union will issue you a line of credit with a set spending limit.
HELOCs are split into two periods. You have the draw period where you can draw funds from the line of credit, and then the installment period, where funds are no longer available to draw, and a locked repayment period begins. During the draw period, your monthly HELOC payments only require you to pay the interest on the amount you’ve borrowed, whereas the installment period payments are interest and principal. It is recommended to pay more than the interest during the draw period to pay the line of credit off or down before the installment period begins. The existing balance at the end of the draw period is amortized over the installment term, typically 10 to 15 years. Draw and repayment period terms can vary from lender to lender. Make sure that the terms of your HELOC align with your overall goals.
Additional payments made towards the line of credit will lower the total interest paid. Monitor the balance to make sure you can repay the loan on time. Unlike home equity loans, the interest rates on HELOCs may vary over time, which means your monthly payments will as well.
When to Use HELOCs
HELOCs are a great choice if you need flexibility and may not know exactly how much you’ll need or when you’ll need it. Since they are revolving lines of credit, HELOCs may also give you quick access to cash if a large, unexpected expense comes up. Many homeowners will borrow to make renovations on their property. It can also go towards debt consolidation, paying for college, emergency expenses, business ventures or other major life purchases.
How to Qualify
Depending on the lender, you may need a certain amount of equity in your home; generally, 20% is the typical minimum. 20% equity means that you have paid down 20% of the principal balance on your mortgage. If you own the home free and clear, you effectively have 100% equity. Your credit score, as well as other factors such as debt-to-income ratio, can affect the interest rate and approval odds.
How to Calculate Your Home Equity
As you consider this option, you will need to calculate your existing home equity based on the estimated value of your home. The lender may need to conduct an appraisal of your property to determine its value by sending an appraiser to look over the property. Once the lender has established the value of your home, find out how much you still owe on your mortgage or the remaining balance.
To calculate the amount of equity in your home, subtract how much you still owe on your mortgage from the estimated value of your home.
For example, if your home is worth $250,000 and you still owe $150,000 on your mortgage ($250,000 - $150,000) equals $100,000 or 40% equity ($100,000 divided by $250,000)
The more equity you have, the larger the Home Equity Loan or HELOC you may qualify for. Lenders will usually lend no more than 85% of your home equity, this cap varies per Lender. To see how much you can borrow, multiply 0.85 by your home equity. Using the example above, you could potentially borrow up to $85,0000 ($100,000 x 0.85).
Regular monthly payments on your mortgage will continue to build the amount of equity in your home. Additional payments made towards the mortgage will make that equity grow quicker.
How to Get Started
You will need to get your financial records together as you get ready to apply for a home equity loan or HELOC, such as proof of income, existing debts, bank statements and other necessary documents. The lender may schedule an appraisal of your property if you choose to put in an application.
Take your time evaluating your options when talking to various lenders. You may be able to lock in a lower interest rate by joining your local credit union. They tend to be more flexible with their lending requirements compared to large banks.
Nothing could be more important than your home, so use the money wisely and never borrow more than you can repay. You should only use the money for large purchases, home renovations, debt consolidation, furthering your education or other purchases that can help you meet your goals.
As you can see, there are clear differences between home equity loans and HELOCs, yet both depend on the equity of your home. Contact the professionals at Ent Credit Union to learn more about home equity loans and HELOCs.
Use the following calculator to help decide which option is right for you.