Should you require a substantial amount of funds—perhaps for an unexpected medical bill, a renovation endeavor, or any other significant life expenditure—you'll likely begin exploring the most suitable borrowing avenue for your particular circumstances. Specifically, if you own your residence, you may contemplate leveraging your property's equity through either a home equity loan or a home equity line of credit (HELOC). However, which option presents the superior selection?
TL;DR
- A home equity loan provides a lump sum with fixed payments, suitable for single large expenses.
- A HELOC offers a flexible credit line, allowing repeated borrowing and repayment, ideal for ongoing needs.
- Both options use your home as collateral, risking foreclosure if payments are missed.
- Eligibility requires homeownership and significant equity, typically 15-20% or more.
Utilizing your home's equity for a loan might offer an economical method to acquire necessary funds, potentially featuring advantageous interest rates and adaptable repayment schedules. However, it also carries significant peril, given that your residence serves as security, implying the possibility of forfeiture if you fail to meet repayment obligations.
We'll guide you through these two methods of accessing your home's value, with one functioning as installment financing and the other as a flexible credit line akin to a credit card.
What is a home equity loan?
Consider a home equity loan akin to a collateralized personal loan. It represents a method of accessing the equity accumulated in your residence as you reduce your mortgage balance. The funds disbursed from a home equity loan are secured by your real estate; consequently, failure to repay the loan could result in the lender foreclosing on your property to recover the outstanding debt.
Upon obtaining a home equity loan, a single sum will be transferred to your financial institution. Its application is versatile, much like that of a personal loan. You'll be placed on a repayment schedule with consistent monthly payments until the entirety of the loan, including interest, is settled. The repayment period for your loan could extend up to three decades.
Key distinctions exist between a personal loan and a home equity loan, though. Home equity loans permit you to borrow potentially greater sums than a standard personal loan, which frequently has a ceiling of $100,000. Based on the amount of equity you've accumulated, a home equity loan could provide hundreds of thousands of dollars in borrowing capacity. The interest rate may also frequently be less than that of many other loan varieties.
However, obtaining a home equity loan might incur significant expenses. Certain financial institutions impose charges for services such as loan origination, credit checks, property title investigations, and other associated costs.
Advantages and disadvantages of a home equity loan
Pros
- APR is fixed for the duration of your loan
- Predictable monthly payments
- Typically slightly lower APR than a HELOC
Cons
- You’ll pay interest on the full borrowed amount (whether you use it immediately or not)
- You may lose your home if you fail to pay off your loan
- Lowers your home equity until repaid
What is a HELOC?
A home equity line of credit shares similarities with a conventional home equity loan, as both involve borrowing against your property's value. You'll probably find attractive APRs and the possibility of a larger loan sum than with a typical personal loan; however, failing to repay your loan could result in losing your residence.
A key distinction between a home equity loan and a HELOC lies in how you access your funds. Rather than receiving a single, immediate disbursement, your money is provided as a flexible credit line, much like a credit card, allowing you to borrow as required instead of taking the entire amount at once. You'll incur interest solely on the amount of your credit line that you've drawn upon.
A HELOC consists of a “draw” phase and a “repayment” phase. The borrowing phase commences when you secure your loan and may extend for as long as a decade. Throughout this duration, you have the flexibility to withdraw and reimburse funds largely at your discretion. Once this phase concludes, the repayment phase commences. You'll be unable to access your credit line further, and you'll be obligated to settle the balance—either in a lump sum or via a monthly payment schedule. Analogous to a home equity loan, the repayment phase can span many years.
Additionally, you might consider refinancing your HELOC to restore access to your credit line.
You'll likely encounter comparable closing expenses for both a HELOC and a home equity loan, ranging from appraisal charges to processing fees.
Pros and cons of a HELOC
Pros
- Revolving credit structure lets you reuse this financing method multiple times
- You’ll only pay interest on the funds you use
- Initial interest-only payments keep upfront costs low
Cons
- You may lose your home if you fail to pay off your loan
- Interest rates are typically variable
- Lowers your home equity until repaid
Ways to access your home's equity for a loan
To qualify for either a home equity loan or a HELOC, you’ll have to:
- Be a homeowner
- Have considerable equity your home
Equity represents the worth of your property less any outstanding mortgage balance. Financial institutions typically mandate that you maintain a home equity of 15% to 20%. Consequently, you can usually secure financing for amounts exceeding that threshold.
Should your residence be valued at $350,000 and you have a $200,000 outstanding mortgage balance, you possess $150,000 in equity, representing 43% of its worth ($150,000 in equity divided by $350,000 total valuation). If a 20% equity retention is mandated, you'd be permitted to borrow as much as 23% of your accumulated equity.
Beyond this stipulation, lenders also look for a good credit profile, proof of income and employment, and reasonable debt-to-income ratio, preferably below 40%.
Choosing between a home equity loan and a HELOC
Consequently, you've concluded that tapping into your home's equity represents the optimal approach for financing your significant forthcoming expenditures. Should you remain uncertain about the most suitable option, consider these inquiries.
What is the purpose of the funds you require?
For a substantial one-time expense, a home equity loan could be a suitable option. These loans feature clear repayment schedules and a stable annual percentage rate. Alternatively, a HELOC might be more advantageous if you don't require the full sum right away but anticipate drawing from it over time, as you'll be billed interest solely on the funds you've accessed, not the total loan principal.
Will these funds be allocated to recurring expenditures?
Should you intend to tap into your equity on multiple occasions, a HELOC emerges as the superior choice. You can utilize it much like a credit card, yet without the prohibitively high annual percentage rate. Furthermore, it proves useful to maintain as a readily available emergency fund.
Do you want a fixed APR?
Although you might secure a set interest rate for some of your home equity line of credit, this kind of borrowing usually has a fluctuating annual percentage rate. Whether that proves advantageous or disadvantageous hinges on economic circumstances and Federal Reserve choices.
Generally speaking, your interest in a Home Equity Line of Credit (HELOC) tends to be less certain compared to a home equity loan, which features interest rates that are fixed when the account is established.
How much equity do you have?
Should your home equity be limited, a home equity loan might not be the most suitable selection. A more advantageous approach could involve establishing a HELOC, which grants you the ability to draw funds from the same credit line repeatedly as you repay it. This enables you to access more credit than your equity permits, though not simultaneously.
You might consider funding a $50,000 home improvement project using your home's equity. Should you possess just $10,000 in equity, a standard home equity loan wouldn't suffice for your requirements. However, a HELOC allows you to purchase supplies and/or compensate for work in increments of $10,000. As you reduce your outstanding balance, you'll regain the ability to access your equity once more.
Alternative methods for funding an acquisition
Beyond a home equity loan and a HELOC, which are two ways to fund your significant expenditures, other frequently selected alternatives are available:
- Buy Now Pay Later (BNPL) services. Certain acquisitions are eligible for buy now, pay later arrangements that divide a cost into several no-interest installments.
- Credit cards. They're well-suited for regular spending that you can settle completely without delay, but they're typically a poor choice for financing significant expenditures requiring extended repayment periods. The annual percentage rate is frequently elevated, although certain credit cards feature an introductory period with no interest, potentially allowing up to a year or close to two to clear your debt without incurring finance charges.
- Borrow money from friends or family. Securing funds for a significant acquisition might be most straightforward and economical when you have the implicit confidence of your inner circle. Nevertheless, it's crucial to establish explicit conditions for reimbursement and adhere to the agreed-upon plan; failing to do so could jeopardize these connections.
The takeaway
While a home equity loan and a home equity line of credit share many resemblances concerning expenses, loan sums, and the consequences of non-repayment, their primary distinction lies in the method of fund disbursement.
A home equity loan provides a substantial amount of money upfront, requiring you to make consistent monthly payments until the debt is settled. A HELOC, on the other hand, functions as a flexible credit line that allows for repeated borrowing and repayment.
Frequently asked questions
Is a home equity loan considered a secondary mortgage on a property?
Indeed, a home equity loan functions as a secondary mortgage. Obtaining a home equity loan signifies that you will subsequently be responsible for both a monthly mortgage installment and a monthly loan installment.
For a substantial single expenditure, which is preferable: a HELOC or a home equity loan?
A home equity loan typically suits a significant, singular expenditure because it features set interest rates and its repayment conditions are foreseeable.
Your monthly payment for a home equity loan might fluctuate.
Your fixed monthly installments for a home equity loan remain constant throughout the loan's duration. Upon account establishment, you'll be set up with consistent payments until the loan is fully repaid.
To be eligible for a home equity line of credit, what percentage of your home's value must you own?
To be eligible for a home equity line of credit (HELOC) or a home equity loan, you generally must possess over 15% to 20% equity in your residence. This requirement stems from the fact that the majority of financial institutions mandate that you maintain a minimum amount of equity in your property consistently.
For a home equity loan or a HELOC, is an appraisal a requirement?
Indeed, an appraisal is typically required for a home equity loan or HELOC, allowing the lender to determine the amount of funds they can offer you.