Building equity is one of the most important benefits of home ownership. Over time, your property may increase your wealth, but that money is only available when you sell or borrow against your home. When it comes to loans, you have several options, including a home equity loan and a home equity credit line (heloc). Each type of loan has advantages and disadvantages, so it is essential to choose wisely.
Heloc versus Home Equity Loan
We drill down in the data below, but the fundamental differences include:
- A heloc is usually a variable interest line of credit that allows you to borrow and repay repeatedly.
- A home equity line of credit is a one-time loan that you repay with fixed payments for more than a certain number of years.
In some ways, mortgage loans and HELOCs are similar:
- Second Mortgages: Both loans are often second mortgages that you can use in addition to an existing home purchase loan.
- Home equity: You borrow against the equity in your home, which is the value of your home that you actually own after accounting for a mortgage loan balance.
- Secured by your home: Both loans use your home as collateral. If you stop making payments, your lender can potentially force you out of your house by foreclosure. Putting your house on the line is risky, especially if you use the loan for expenses that do not improve the value of the house.
HELOCs offer flexible loans
A heloc offers a pool of money that you can withdraw from if needed. Your lender sets a maximum borrowing limit, and you can use as much or as little as you need, equal to a credit card.
The expenses: HELOCs usually feature a ten year “draw period” during which you can borrow multiple times. To access the funds, you can often write checks, use a payment card attached to your loan, or transfer money to your bank account.
Payments: During the draw period, you may have the option to make small, interest-only payments on your debt. Eventually you will come to a repayment period where your payments will go in the direction of both principal and interest. Once you start the repayment period, you can no longer borrow.
Interest: HELOCs have a variable interest rate, and must start with a lower interest rate than home equity lines of credit. But if interest rates rise, your financing costs may increase.
Interest costs: You can minimize the interest costs by keeping a small balance (or zero balance) on your heloc only when you need money. Compare this with mortgage loans, which charge the interest on the full amount of your loan starting in the first month.
Home equity loans are predictable
A home equity loan gives you a lump sum. You and your lender agree on an amount, and you receive the full amount in one transaction.
Spending: Because you receive everything at once, a home equity loan can finance large expenses. If you pay multiple fees or pay over time you can keep the excess amount in your bank account and spend it as needed.
Payments: You pay most mortgage loans with fixed monthly payments. The amount to be paid and the interest usually do not change over time. Instead, your bank calculates a repayment schedule that includes both your interest costs and the loan repayment in each monthly payment.
Interest: The interest is usually fixed, allowing for predictable, level monthly payments.
Interest costs: You pay interest on your entire loan balance, and your interest costs are highest at the start of your loan. To see how mathematics works, learn about loan amortization. You can minimize the interest costs by paying off your loan early, assuming there are no penalties for early repayment.
How much can you borrow?
Lenders limit how much you can borrow with both mortgage loans and HELOCs. In most cases you can borrow up to 85 percent of the value including all existing debts on the property of your house. Some lenders allow you to borrow more, but the interest and costs increase as you borrow more. For the best conditions, keep your loan-to-value (LTV) ratio below 80 percent.
Example: Your home is worth $ 300,000, and you owe $ 100,000 on your original mortgage purchase. How much is available for a second mortgage (assuming you have sufficient income and credit scores to qualify)?
- Home value: $ 300,000
- Existing mortgage debt: $ 100,000
- Maximum debt amount, assuming 80 percent LTV: $ 240,000 (multiply 0.80 by $ 300,000)
- Amount available to borrow: $ 140,000 (subtract the existing debt of $ 100,000 from the 80 percent maximum of $ 240,000)
Heloc Versus Home Equity loan: Which is the best?
These loans work differently, and it makes sense to adjust your borrowing to your needs.
For flexibility: A heloc allows you to borrow and repay many times over a ten-year period. Getting money is as easy as writing a check or wiping a payment card – you don’t have to apply every time you need more money. Pay off the balance if you are able to do this, and borrow again if necessary.
For predictability: works A home equity loan if you know exactly how much you need and you want predictability when it comes to repayment. Your monthly payments will not rise as interest rates increase, and you don’t have to worry about your lender freezing your credit limit or cutting your credit limit.
To minimize interest: With HELOCs, you only pay interest if you borrow money. You can open a credit line and decide not to use if you want.
Debt consolidation? Consolidating loans such as credit cards and car loans can be risky if you use equity at home. By pledging your home as collateral, you can convert unsecured loans into secured debt. But a home equity loan can turn high-interest debt into a low, fixed interest rate. The resulting savings can be significant, but make sure you don’t go back in debt. A home equity loan gives you only one chance to borrow, making it a little safer than a heloc.