Home Equity Loans vs. HELOCs
Comparing the Two Types of Equity Loans
Whether you're sending a family member to college, you'd like to make some home improvements or consolidate debt, or an unexpected expense has come up, you can access your home's equity by taking out a second mortgage. Perhaps the value of your home has increased, you've been making payments on your home mortgage for a while, or a combination of both — either way, you've built valuable equity in your home.
There are two methods to access your equity, by taking out a home equity loan (HEL), or through a home equity line of credit (HELOC). These are known as second mortgages and are not to be confused with a cash-out refinance loan. The differences may seem subtle, but once you're informed, you'll be able to choose which loan is the right one for your situation.
How much home equity do I have?
Determine your equity by subtracting the balance you owe on your mortgage from the fair market value of your home and property. Lenders will use a loan-to-value ratio (LVR), the amount you currently owe on your home and the amount you want to borrow, compared to its value, to determine whether they will grant you a second mortgage.
Please note that just like your first mortgage, you are putting your home up as collateral for a second mortgage. The advantage of a second mortgage, when compared to other types of loans, is the relatively lower interest rate.
What type of home equity loan is best for you?
The first question you need to ask yourself before deciding the between the second mortgage options is, “Do I need a lump sum right now to pay off a major expense, or do I need to access cash periodically?” The next question is, “Do I plan to pay this loan off quickly, or do I plan to make payments for an extended time?”
As you learn about the types of loans available to you, you might answer some of these questions.
What is a Home Equity Line of Credit (HELOC)?
A HELOC is a line of credit, similar to what you receive from a credit card company. You borrow the amount you need when you need it, and you pay interest only on the amount you borrow. Typically, HELOC loans have a variable interest rate that is subject to increase or decrease. These rates are related to the performance of a specific index, plus a margin, which is detailed in your HELOC loan documents. This means that your monthly minimum loan payment could increase or decrease over time.
One advantage of a HELOC is that the initial interest rate can be lower than that of a home equity loan. This makes it an attractive loan should you plan to pay the loan off in the short term. Experts say a HELOC is a good solution for shorter-term goals such as a year or two. You can continually draw upon your HELOC, while partially repaying it or paying it off in full, during the drawing period. After the drawing period ends, or if you borrow the entire equity amount, you are not able to borrow any more money.
Another advantage to a HELOC is that your lender may offer you interest-only payments during an initial draw period, which could last as long as ten years. If you take advantage of an interest-only loan, make sure to budget for increased monthly principal and interest payments during the repayment phase of your HELOC loan, which could last as long as 20 years.
What is a home equity loan?
This is a loan you take out in addition to your first mortgage. When you choose to take out a home equity loan, you will receive a one-time lump sum. A home equity loan is a good option if you know exactly how much money you need to borrow. Home equity loans feature a fixed interest rate, which makes your monthly payment consistent no matter what happens to interest rates. A fixed payment also makes budgeting easier. Your monthly payments will apply to both the principal and interest from the beginning. You can work with your lender to determine the term of your loan, which can be between 5 to 30 years.
Home equity loan advantages
Because you start making loan payments on the entire amount of your home's equity that you have borrowed, a home equity loan is a good source to fund a large-scale project or one-time expenses. If you plan to carry the loan for a long period of time, a home equity loan might be the right choice for you because interest rates are not subject to change.
Questions to ask when taking out a second lien
Interest payments for both of these types of loans up to $100,000 can be tax deductible. Ask your tax preparer whether your second mortgage loan qualifies.
The terms of your loan
Not all loans are created equal. It's a good idea to ask your lender questions and to compare loan terms. For instance, is there a minimum-sized draw you can make on a HELOC? Are there any lender fees, annual fees or inactivity fees associated with your HELOC? Are you required to keep a specific balance, or are you charged a fee if you cancel your HELOC? Are there any periodic caps on the amount your HELOC interest rate can increase during each adjustment period? Is there a lifetime cap over the term of the loan that protects you from soaring interest rates?
Once you've taken a close look at both loan options, know how loan payments work with your monthly budget, and decide how long you plan to carry your second mortgage loan, you'll know whether a HELOC or home equity loan is right for you.
If you still need help deciding, check out Credit Union of Texas' Home Equity Loans and HELOC pages.