Homeowners that want to add an addition to their home, or buy a small mountain cabin, often ask the question, "What is a Home Equity Line of Credit (HELOC) vs. Home Equity Loan?" This is an article that just appeared in the AtHomeColorado online newsletter, one of a few high quality Colorado real estate news sources that I read regularly. Written by Ellen Chang of BankRate, the article does a great job of not only describing the differences between the two, but also explaining the pro's and con's. Here is the article, in its entirety...
Home equity lines of credit (HELOCs) and home equity loans are loans backed by your house, and they’re great ways to borrow money if you’ve paid down a significant portion of your mortgage. A HELOC is a line of credit that allows you to borrow as much as you need over time with variable interest, while a home equity loan is a lump sum that is disbursed upfront and paid back in fixed installments.
Most home equity loans and HELOCs allow you to borrow up to 85% or 90% of the value of your home, and they typically have low interest rates and fair terms, since you’re using your home as collateral for the loan. Before you settle on a home equity loan or line of credit, you should shop around to find an option with the lowest fees – or no fees if possible.
What is a home equity loan?
Home equity loans let you borrow against the equity in your home with a fixed interest rate and fixed monthly payment. These loans are funded in a lump sum, and you’ll pay back funds over five to 30 years. Because home equity loans have fixed interest rates, your monthly payment will never change.
How can you use the money you receive from a home equity loan? It’s really up to you. Some consumers use it to pay for major repairs or renovations, such as adding a new room, gutting and remodeling a kitchen or updating a bathroom. Another common use is taking out a home equity loan with a low, fixed rate to pay off high-interest credit card debt.
Pros of home equity loans:
• Secure a low, fixed interest rate, fixed monthly payment and fixed repayment schedule.
• Borrow a lump sum you can use for any purchase you want.
• Some home equity loans don’t have any fees.
• Loan interest may be tax deductible if used to remodel or improve your home.
Cons of home equity loans:
• The best home equity loan rates and terms go to consumers with good or excellent credit.
• You need a lot of home equity to qualify.
What is a HELOC?
A HELOC, or home equity line of credit, is a line of credit similar to a credit card. With this loan, you can borrow up to a specific amount of your home equity and repay the funds slowly over time.
HELOCs have a draw period, or a period of time in which you can access the money, that typically lasts around 10 years. During this time, you’ll be responsible for interest-only payments. That’s followed by a repayment period, where borrowing must cease and monthly principal and interest payments are required. This repayment period usually lasts 10 to 20 years.
HELOCs tend to come with variable APRs, meaning your interest rate could go up or down based on market trends. Due to the variable interest rate and the fact that you can tap the funds on your own timetable instead of getting it all upfront in a lump sum, this option may be better for consumers who aren’t 100% sure how much cash they need or who have long-term financial needs, like college tuition payments.
Pros of HELOCs:
• Only borrow as much money as you need.
• Many HELOCs come without any fees.
• Repayment options can be flexible.
• You may be able to deduct the interest on your HELOC on your taxes if you use the funds to improve your home.
Cons of HELOCs:
• Variable interest rates can change with the whims of the market.
• You need considerable equity to qualify.
Key differences between HELOCs and home equity loans
Some of the major differences between HELOCs and home equity loans are:
• Fixed vs. variable interest rates: Home equity loans come with predictable, fixed monthly payments. HELOCs have variable rates, meaning your rate may rise and fall over time.
• Average APRs: Rates fluctuate with the market, but in general, HELOCs have slightly lower interest rates than home equity loans.
• Funds disbursement: Home equity loans deposit the full sum of your loan upfront. HELOCs, on the other hand, allow you to draw only as much as you need, when you need it, and replenish your line of credit by making payments.
• Repayment terms: With a home equity loan, you begin making payments as soon as you receive your loan. With HELOCs, the first five to 10 years typically require interest-only monthly payments, but in the last 10 to 20 years you’ll pay back both interest and principal.
How much home equity can you tap?
To find out how much home equity you have, subtract the amount you still owe on your mortgage from the value of your house. The difference is the amount of home equity you’ve accrued, and part of that amount can be used as collateral for a loan.
The amount of money you can tap varies based on your lender and if you’re considering a home equity loan or a line of credit. The maximum is typically around 85% of your home’s value, though some lenders will go as high as 90 percent. The amount you should tap depends on what you’re hoping to use the money for; in general, try to tap the minimum amount you think you’ll need for your goals.
Best ways to use a home equity loan or HELOC
The proceeds of a home equity loan or a HELOC can be used to pay down high-interest debt, including any credit card debt you have. Since the average credit card interest rate is currently around 16 percent, it’s easy to see how consolidating debt with a HELOC or home equity loan charging 5% could help you save money or get out of debt faster.
Another benefit of using home equity to consolidate debt is the fact that you can often go from having to make multiple payments each month to making just one. In other words, you could save money by consolidating and simplify your financial life by reducing the number of bills you pay each month.
In addition to debt consolidation, you could lean on home equity to complete a major home remodeling project, pay for major home repairs or even fund college tuition. Since you can use funds from a home equity loan or HELOC however you want, it’s really up to you.
Just remember that using your home as collateral for a loan does come with risk. If you were unable to make the monthly payments, you could lose your home to foreclosure.
Another risk is if the value of your home declines and you need to sell. In that case, you could end up owing more money than what your home is worth, or be “upside-down” on the loan at the worst possible time.
How to choose between a home equity loan and HELOC
Still can’t decide between a home equity loan and a HELOC? Both options can be good ones, but one is probably better for your needs.
As you continue researching loans, get quotes for both HELOCs and home equity loans to see which one might offer a lower interest rate, lower fees and better terms. Also consider these scenarios where a specific option might leave you better off.
A home equity loan could be better if:
• You know the cost of your project and need to borrow a lump sum of money.
• You prefer a fixed interest rate that will never change.
• A fixed monthly payment you can count on fits well into your lifestyle.
• You want to consolidate high-interest credit card debt at a lower interest rate and pay it off with a fixed repayment plan.
A HELOC could be better if:
• You want the ability to borrow as little or as much as you want – when you want.
• You have upcoming expenses like college tuition and don’t want to borrow until you’re ready.
• You don’t mind if your payment fluctuates.
Can you have a HELOC and a home equity loan?
There is theoretically no limit to the number of home equity loans or lines of credit you can hold at one time. However, it will be harder to qualify with each new application, since you’ll have less and less equity to tap with each successive loan.
If, for instance, you have a home valued at $500,000 and you have two home equity loans totaling $425,000, you’ve already borrowed 85% of your home’s value _ the cap for many home equity lenders.
Lenders may also charge higher interest rates on additional loans or lines of credit, especially if you’re asking for a second loan from the same lender. As with any loan product, it’s best to shop around with a few lenders before accepting a loan offer to make sure you’re getting the best rate possible.
By Ellen Chang, Bankrate.com. Visit Bankrate online at www.bankrate.com
Image by Nattanan Kanchanaprat from Pixabay
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James Sack, REALTOR®
Coldwell Banker Residential Brokerage
1109 Oak Park Drive | Fort Collins, CO 80525
C: (970) 217-9705 | O: (970) 223-6500 | E: James.Sack@coloradohomes.com | W: www.JamesSack.com