What Is A Home Equity Loan & Home Equity Line Of Credit (HELOC)?

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What Is A Home Equity Loan & Home Equity Line Of Credit (HELOC)?


The more you pay down your mortgage, the more equity you build in your home. And home equity? That can be turned into cash.

One of the most common ways to do this is with a home equity loan — a type of second mortgage you take out against your house.

Are you in need of a little extra money these days? Here’s what you need to know about home equity loans — as well as how (and when) to use one.

What’s a home equity loan?

What Is A Home Equity Loan? - What is a home equity loan?

To understand these loans, you first need to understand home equity — the stake in the home you actually own. Mathematically, your home equity is your home’s value minus your current mortgage balance (that’s the part the lender owns). 

Once you have a good amount of home equity built up, you can use it as collateral for a new loan, essentially turning that equity into cash. 

To be clear: home equity loans are a type of second mortgage. If you fail to repay one, the lender can foreclose on your house to cover their losses. And just like your first mortgage, these loans come with interest costs and monthly payments. This means you’ll have two payments once you’ve closed on your loan: one for your initial mortgage and one for your home equity loan. You’ll want to be sure you can cover these double payments before moving forward.

What can you use a home equity loan for?

Home equity loans can be used for a whole slew of purposes, including things like home renovations and repairs, college tuition, medical bills, emergency expenses, and more. There’s no limit, really.

If you opt to use the funds to improve your house (and only for that purpose), you may be eligible for an extra tax write-off for that year. The exact deductions you’re eligible for will depend on your tax filing status and other factors, though, so talk to a tax advisor if you’re planning on using your home equity loan for these purposes. 

Home equity loans vs HELOCs

  Home equity loan HELOC
Interest rate Usually fixed Usually variable
Payments Paid monthly from the start Paid after the draw period closes (usually 10 years)
Type of product Loan/second mortgage Line of credit
Amount Lump sum Can draw funds as needed

It’s easy to confuse home equity loans with home equity lines of credit (or HELOCs). Though both leverage your home equity, the two are very different financial products.

While home equity loans function like a second mortgage, with a fixed monthly payment and set interest rate, HELOCs are more like credit cards. There’s no fixed borrowed amount; instead, you pull from a line of credit as needed — like you would a credit card.

You can withdraw from your HELOC for a set period of time — called the “draw period.” After that point, you enter the repayment period, which is when you begin making payments toward what you borrowed. Unlike home equity loans, most HELOCs have variable interest rates, meaning your rate (and payment) may rise or fall over time. 

Pros and cons of home equity loans

Home equity loans have their pros and cons. They’re a great way to get extra cash when you need it and, like mortgages, they also come with low interest rates — especially compared to pricey options like credit cards and personal loans. Even better? They have fixed interest rates. This provides consistency and makes it easier to budget in both the short and long term. 

In some cases, they might also mean an extra tax write-off, which can help save you come April (or maybe increase your refund).

Still, there are some major drawbacks to using these products. For one, they use your home as collateral. If you fall behind on payments, that might mean losing your home.

Home equity loans also mean a second monthly payment. If you’re not careful about your budgeting and spending, it could put you in a bind financially. 

Finally, there are also closing costs to think about. Just like with your initial mortgage loan, a home equity loan will come with various fees and expenses come closing day. In some cases, lenders may offer alternatives, like rolling the cost into the loan balance (which means more paid in interest over time) or waiving the costs altogether. This option typically comes with a pre-payment fee, meaning if you pay off the loan too quickly, you might be charged a penalty.

Who are home equity loans best for?

What Is A Home Equity Loan? - What are home equity loans best for?

Homeowners with high-interest debt

If you have a lot of high-interest debts, for example — credit card balances, personal loans, or car loans — a home equity loan can often be a smart move. Because home equity loans come with lower interest rates than these products, using your home equity to pay these debts off means paying less interest in the long run. 

Those renovating their home

They’re also a good idea if you’re using the funds for renovations — and only renovations. In this scenario, you’d likely be due a valuable write-off that could save you come tax season. 

Who shouldn’t get a home equity loan?

Those already short on cash

A home equity loan might not be a great idea if you’re short on cash or struggling financially. Since these loans come with closing costs — as well as a second monthly payment — it could put added financial stress on your household.

Those who don’t have a plan for the funds

You also may want to think twice if you don’t have a concrete plan for the cash. Unlike credit cards and other lines of credit, you’ll pay interest on the entire balance of a home equity loan from day one. If you just want some extra cash available for a rainy day, a credit card or home equity line of credit is probably a better option.

Requirements for home equity loans

The exact requirements you’ll need to meet for a home equity loan will depend on your lender, but generally, you can expect to need:

  • A credit score of at least 620.
  • A debt-to-income ratio of 43% or lower (meaning 43% or less of your monthly income goes toward debts).
  • At least 15% to 20% equity in your home.

Eligibility requirements vary by the mortgage lender, so make sure you shop around if you’re worried you may be on the cusp of ineligibility. It’s possible you qualify with one mortgage company and not another.

How to get a home equity loan

You can get home equity loans from a variety of financial institutions, including banks, credit unions, and dedicated mortgage lenders. Once you find a lender that offers these, you’ll fill out the application, provide the financial documentation required, pay your closing costs, and close on the loan. 

It generally takes around 45 days for a home equity loan to close, though this varies by lender as well.

How much you can borrow with a home equity loan

Most lenders will let you borrow between 80% and 85% of your home’s value — total. That means your current mortgage loan, plus your home equity loan, can’t come out to more than 85% of the home’s value. 

To determine what you could possibly borrow with a home equity loan, use this formula:

  1. (Home value) x (85%) = (Total amount you can borrow between both loans).
  2. (Total amount you can borrow between both loans) – (Your current mortgage balance) = (Amount you can borrow with a home equity loan).

So if your house is worth $300,000, and you have a mortgage balance of $180,000, yours would look like this:

  • $300,000 x 0.85 = $255,000.
  • $255,000 – $180,000 = $75,000.

In this scenario, you could likely borrow about $75,000 using a home equity loan. Just keep in mind that not all lenders will allow you to borrow up to 85%, so be sure and check with yours before making commitments with the loan funds.

Home equity loan alternatives

What Is A Home Equity Loan? - Alternatives to home equity loans

Home equity loans aren’t the only way to use your home equity to your advantage. You might also think about these alternatives:  

  • HELOCs. HELOCs — or Home Equity Lines of Credit — are similar to home equity loans, but instead of a single, lump-sum payment, you can use the funds as needed, much like a credit card. This allows you to spend as much or as little as you like. In most cases, HELOCs have adjustable interest rates that can change over time.
  • Cash-out refinances. A cash-out refinance is an option if you’d like to tap home equity, while also replacing your current mortgage loan. This can be a good move if mortgage rates are lower than what’s on your existing mortgage.
  • Equity sharing. This is an arrangement offered by companies like Hometap. Instead of giving you a loan or line of credit against your equity, the company buys a stake in your equity, essentially co-investing in your home. Then, when you sell the house, they take a share of the proceeds.

If you need cash but aren’t sure of the best move, consider talking to a financial advisor for guidance. They can help you determine the best path for your individual goals.

Summary

Home equity loans can be a good way to access cash for homeowners, but they’re not right for everyone. Be sure to weigh the pros and cons of these loans and have a plan for that second monthly payment before taking one out. 

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