For many, your home is your most valuable asset. As you pay off the terms of your loan, you gain equity in your home.
Home equity is the difference between the home’s value and the outstanding mortgage balance. It is the part of the home you own. If you want to complete a home improvement project, consolidate debt, or need the money for another reason, you may want to consider tapping into your home equity.
While this may be less popular than it used to be, we’ll discuss all you need to know about using your home equity. This article explores key differences between home equity loans and home equity lines of credit and answers some commonly asked questions to help you navigate the process.
In the end, you’ll be ready to decide if accessing your home equity is right for your finances and know where to turn to get the best help during this process, no matter where you are in it.
Understanding Home Equity Loans
A home equity loan is a fixed-interest rate loan that provides a lump sum cash payment. It is based on the amount of equity you have in your home, and your loan will typically be about 80% of the value of your home, less your remaining mortgage.
Often called a second mortgage, a home equity loan requires repayment over a period. While this period varies, it is typically between five and 15 years. Getting a home equity loan has many pros and cons, so let’s explore some of the main ones below:
Benefits
If you want to get a big sum of money from your home equity all at once, then a home equity loan may be for you. This will give you immediate access to your funds to do what you need to do with a consistent monthly payment after the fact.
Additional benefits of a home equity loan include:
- Fixed interest rate: The rate on your monthly payment does not change over time, so you can easily budget for your payment over the term of your entire home equity loan.
- Consistent monthly payments: Your monthly payment will not change over the lifetime of your home equity loan because it is based on the full loan amount from the start. Your monthly payments will be equal throughout the loan.
- Lower interest rates: A home equity loan may have lower interest rates than personal loans or credit cards. If you need a large amount of money upfront, it may be better to tap into your home’s equity than take out a more costly option in the long term.
- Tax deductible: If you used your home equity loan to improve your house, you could write off the loan interest on your taxes during the entire term of your loan.
- Closing costs: Your annual percentage rate (APR) will reflect all closing costs on your home equity loan, so you don’t have to worry about surprises or hidden fees. You will pay all closing costs at once when you close your loan.
- Early payment: There are no fees for paying off your home equity loan earlier than your repayment period.
If you intend to make a big purchase and know how much it will cost, you may want to get a home equity loan. Its lump sum and consistent payments make it an attractive option for many.
Drawbacks
Because it’s a second mortgage on your home, a home equity loan carries an increased risk of foreclosure if you default on the loan payments.
Additional drawbacks of a home equity loan include:
- Higher rates: While you have a fixed interest rate, it is often higher than a HELOC. However, it is still lower than a personal loan or credit card.
- High closing costs: Home equity loans often have 2% to 6% closing costs, similar to a mortgage.
- High home equity: Typically, you need at least 15% to 20% home equity to qualify for a home equity loan.
Do not take out home equity loans if you risk being unable to repay them. You could lose your home.
Understanding Home Equity Line of Credit (HELOC)
A home equity line of credit (HELOC) is almost like a credit card that taps into your home’s equity. It’s a revolving line of credit from which you can draw money as needed during the loan term.
You can take out a maximum amount, but you can pay the balance down to zero and reuse the line of credit as needed. This is the draw period, and once it ends, you’ll either need to pay the balance back in full or make payments on a fixed payment schedule over time. Let’s explore some of the pros and cons of getting a HELOC:
Benefits
You can access your funds on an as-needed basis, which is great if you plan to make multiple purchases. It can also help ensure that you spend only as much as you need, as long as you have the self-control to avoid overspending.
Additional benefits of a HELOC include:
- Lower rates: Because you have a variable interest rate, your rate is typically lower on a HELOC than on a home equity loan, personal loan, or credit card.
- Consistent access to money: You can access your money over time without needing to adjust the line of credit during the term of your loan.
- Flexible payment structures: Since you only pay back what you spend, your monthly payment is based on your current balance. During the draw period on your HELOC, you can make interest-only payments on your balance.
- Tax deductions: Your interest may be tax deductible if you use the funds to complete home improvements, just like home equity loans.
You will get low monthly payments during the draw period, which is great if you can zero out your balance.
Drawbacks
While the variable interest rate is lower, it will change over time. If you are not careful, paying your monthly payments can be incredibly difficult because, unlike a fixed-rate mortgage, you don’t know what to expect.
Additional drawbacks include:
- Monthly payment increases: Because you have a variable interest rate, they can fluctuate over time, causing high monthly payments. Your monthly payment can skyrocket, especially after the draw period ends and your repayment period begins.
- Annual fees: Depending on the terms of your loan, you may need to pay annual or membership fees yearly. These are in addition to the closing costs you paid on your HELOC at the beginning.
- Credit limit changes: If your home loses value, the lender can lower your credit limit or freeze it altogether.
- Early payment fee: You may be charged if you pay your credit line off too early, so you’ll want to check the terms of your loan to ensure you avoid any penalties.
If you default on your HELOC, you could lose your home. Therefore, you’ll want to be certain you can repay the loan, especially with its variable payments following the draw period.
Choosing Between a Home Equity Loan and HELOC
Now that you know a little about home equity loans and HELOCs, you may wonder how to choose between them when you need to borrow money. They are similar, but key differences could impact your choice based on your finances.
Consider Your Needs
First, consider your financial needs. Do you have a specific project requiring a large upfront sum? If so, a home equity loan may be right for you.
If you prefer ongoing access to funds to help with home improvement projects or unexpected costs over time, you should pursue a HELOC. This line of credit is similar to a credit card debt, giving you access to your home’s equity as needed.
Both home equity loans and HELOCs give you access to funds. It depends on the volume at which you need to access more money.
Interest Rates
Another big difference between home equity loans and HELOCs is the types of interest rates. Home equity loans are fixed-rate loans, which means you have more consistent fixed payments over the lifetime of your loan.
HELOCs are variable-rate loans, which means the interest rate will change over time based on the current market rates. This could be beneficial if the market has low rates, but it could make your loan payments skyrocket if the rates are higher. Check with your lender to see current rates and explore the impact they could have on your payment schedule.
Financial Discipline
HELOCs require a strong level of financial discipline to prevent overspending. You can access much credit over time with relatively low payments until the draw period ends. Can you trust yourself with that amount of money? Can you manage variable interest rates and afford the payments if they increase?
If the answer is no, you should explore a home equity loan because of its fixed rate. You still need financial discipline to ensure you’re spending the money as it was intended. However, if it is funding an active project, it is often easier to do so because you know the exact budget.
Impact on Your Homeownership
Both home equity loans and HELOCs use your home as collateral, so late payments and defaults (as with missed mortgage payments) could lead to your home being foreclosed upon. Considering the overall impact on your homeownership is in your best interest. If you have other options, you may want to explore alternatives if there is a risk you cannot make the principal and interest payments.
Taxes
Home equity loans and HELOCs can be used for anything. However, when you use them for home improvements, you can write off the interest payments on your taxes. You’ll want to consult a tax advisor before you do, but home improvements may be tax-deductible for a home equity line of credit and home equity loan.
Closing Costs
Because you’re originating another loan or a credit line to access funds, you will be subject to closing costs for a home equity loan and a HELOC.
This includes appraisal costs, origination fees, and other closing costs. These closing costs are upfront for a home equity loan and do not change over time. For a HELOC, you may be subject to additional fees over your contract term after you pay closing costs.
Home Equity Lines of Credit vs. Home Equity Loans
If you want to access your home equity, you have options. Because they’re similar, it can be challenging to know if a home equity loan or a HELOC is best for you based on your financial goals.
The short answer is that if you have a specific project with a budget in mind for which you need a lump sum, consider a home equity loan. If you want ongoing access to funds (revolving credit), have a more flexible project, and are unsure how much it will cost, go with a HELOC.
Thankfully, Arnaiz Mortgage can help you with both. We’ll help you navigate the process, partnering closely to ensure you secure the suitable option. If you are ready to get started or have more questions, contact us at (623) 806-4645 or tarnaiz@arnaizmortgage.com today to get started.
We are here for you every step of the way.
Home Equity Loan vs. HELOC FAQs
Because there are many similarities, it can be challenging to determine which is right for you. Let’s explore some common FAQs:
Is HELOC the same as a Home Equity Loan?
No, HELOCs are not the same as a home equity loan. While both options tap into your home’s equity, a HELOC is a credit line. HELOCs have lower interest rates and greater payment flexibility. Home equity loans are fixed-rate loans that provide a lump sum at once, making it better if you need the money upfront.
Is HELOC cheaper than Home Equity Loan?
It depends on the current market rates. The average HELOC rate may be lower than the average home equity loan rate. However, these interest rates are always subject to change, and estimates are based on the market average, not an individual’s financial situation. Therefore, you must contact your mortgage lender for current rates.
What is the monthly payment for a $50,000 HELOC?
The typical monthly payment on a 30-year HELOC depends on the interest rate in the loan contract. Therefore, please contact your lender for more information specific to your case.
When should you get a HELOC or Home Equity Loan?
HELOCs are great for home renovations, including remodels, additions, and renovations. You can also use them to pay for higher education or fund business start-up costs.
Home equity loans are typically used for home improvement projects, including new heating or air conditioning, appliances, etc. You can use them for medical expenses, car repairs, etc.
Both can help you with a home improvement project, but think twice before using each to consolidate or pay off credit card debt or other revolving debt. Failure to pay them back could result in you losing your home, which can be a much more serious consequence than going into collections for an unpaid credit card. Think twice before you overextend yourself.