Home Equity Loan vs Home Equity Line of Credit (HELOC)

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Rising home values ​​mean 44 million Americans now have that more than $ 6 trillion in wealth tied up in their homes. If you’re one of them, you can probably tap on your equity to get money for a home improvement project, pay off high interest debt, or get you unexpected bills.

But first, you have to choose between a home equity loan versus a home loan (HELOC) line of credit.

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HELOC vs Equity Loan

A mortgage loan and a HELOC are both second mortgagesThat means you will incur additional debt and pledge your home as a guarantee that you will pay back your loan.

But mortgage loans and home equity lines of credit differ in important ways that can make one more beneficial than another. It all depends on your situation.

Read more: Here’s What You Need To Get A Home Equity Loan, or HELOC

Differences Between a HELOC Loan and Home Loans

Here’s a rundown of the key differences between a home equity loan and a home equity line of credit.

Home equity loan Home equity line of credit (HELOC)
Second mortgage Yes Yes
Payout Cash in advance in one go Withdraw cash if necessary, up to the limit
Refund Fixed monthly payments Open end. Interest-only payments are often allowed during the drawing period
Interest Typically resolved Usually variable
Interest charges Interest charges apply to the full balance of the loan Only pay interest on the amount you withdraw
Points, Closing Fees and Fees The lender may charge points, closing costs and fees No points, closing costs can be lower
Disclosures Full estimate of mortgage loans and closing statement Less comprehensive information about Truth-in Lending

With both a mortgage loan and a HELOC, pay attention to not only the interest rate, but also the closing costs and lender costs, which play a role in your total repayment costs. To help you assess the impact of these fees, lenders should include them in your annual percentage (APR).

With a mortgage loan, you often have the option to pay a lender “points” to get a lower interest rate. Keep in mind that if you choose to pay points to get a lower rate on your loan, it will take some time to recoup that outlay.

You won’t take full advantage of paying points if you pay off your mortgage ahead of schedule. For example, if you take out a 10-year equity loan and sell your home three years later, you usually have to pay off your loan at that point.

When a HELOC makes sense

  • You may need money in the future, but you don’t know how much
  • You have unpredictable ups and downs in your income
  • You are comfortable with a variable rate

The main difference between a HELOC and a mortgage loan is that with a mortgage loan, you receive your loan in one go – the proceeds are ‘paid’ to you in a single advance payment.

A HELOC is a revolving line of credit that works more like a credit card – you’re approved for an upper limit at which to withdraw if needed. But like credit cards, HELOC rates are typically higher than other types of loans, and they are also variable.

The main benefit of a HELOC is that you only make interest payments on the portion of your credit limit that you tapped. This can be useful if you have unpredictable ups and downs in your income and expenses. For example, if you are self-employed, you often have more income one month than the other.

A HELOC can help you get through lean times, without paying interest on money you don’t need. But keep an eye out for minimum draw requirements, which may require you to have immediate access to some or all of the credit limit of your HELOC.

Pros and Cons of HELOCs

Benefits

  • Only pay interest on the equity that you actually tap into at any given time

Cons

  • Usually only available from banks and credit unions
  • Interest is usually a variable rate, which makes monthly payments less predictable
  • Open-ended loans, making it more difficult to predict how long you will make payments and what your total repayment costs will be

When a mortgage loan makes sense

  • You need money now (short term), and you know exactly how much
  • You have to pay a high interest
  • You want the security of a fixed interest rate

If you know exactly how much to borrow, a mortgage loan may be a better option than a HELOC. Mortgage loans typically have lower interest rates than HELOCS, and the rates are usually fixed for the life of your loan.

Because you also have a fixed repayment period – usually 10 or 15 years – you know exactly what your monthly payment will be when you take out your loan.

A mortgage loan may be a better choice than a HELOC if you know that you need a predetermined amount for a specific purpose, such as a home improvement project or paying off a high interest rate. That’s because you typically get a lower, flat rate than you’d pay on a HELOC.

When using a mortgage loan to pay off a higher interest debt, keep in mind that you can stretch your payments over a longer period of time, negating some or all of the savings you receive by lowering your rate .

For example, if you pay off a five-year car loan with a 10 or 15-year equity loan, you will pay two or three times the monthly payments. They will be much smaller, but it will take you longer to pay off the principal on your loan. Make sure to compare the total redemption costs of both options.

Pros and Cons of Home Loans

Benefits

  • Fixed interest
  • Monthly payment, term and total repayment costs are fixed

Cons

  • A mortgage loan is a second mortgage, so the interest rates can be higher than your first mortgage

How to Calculate Your Home Equity

How much you can borrow with a HELOC or mortgage loan depends on how much of your home you actually own and how much of your equity your lender lets you tap into.

To calculate the equity in your home, subtract your current mortgage balance from the market value of your home.

Suppose your home was recently appraised at $ 300,000. If you only owe $ 200,000 on your mortgage, you have $ 100,000 in equity.

It wouldn’t be a good idea to cash out all of your equity, and most lenders will require you to keep at least a 10% ownership interest in your home. To be on the safe side, many homeowners retain a 20% ownership stake. Think of the amount of equity that lenders will let you get out of your home as your “tappable equity.”

How to Calculate Your Tappable Equity

Lenders calculate your deductible equity by dividing your combined mortgage debt by the value of your home. The higher your combined loan-to-value (CLTV) ratio, the less equity you have in your home.

To calculate how much you can borrow against your home, multiply your home value by the lender’s maximum CLTV and then subtract your existing mortgage debt.

Example: 90% CLTV
Let’s say the lender’s maximum CLTV is 90%, and I feel comfortable borrowing up to that limit, which gives me a 10% ownership stake in my home.

If I multiply my home’s estimated value of $ 300,000 by 90%, that’s $ 270,000 – the maximum amount of combined mortgage debt that this particular lender will let me take out. If I already owe $ 200,000 on my first mortgage, that means I have to borrow another $ 70,000.

Example: 85% CLTV
Let’s look at a different, more conservative example. A lender is willing to let me borrow up to 85% of the value of my home, but I don’t feel comfortable having an ownership interest of less than 20%. So my own self-imposed CLTV is 80%.

By multiplying my home’s estimated value of $ 300,000 by 80%, I see that I have $ 240,000 in total mortgage loan. If I still owe $ 200,000 on my first mortgage, I could take out a second mortgage for $ 40,000 and still have a 20% ownership interest.

Cash-out refinancing is another option

Another way to tap into the equity in your home is to refinance your existing mortgage some money in the process.

With payout of mortgage refinancing, you do not need to take out a second mortgage. Instead, you pay off your existing mortgage with a new mortgage that is large enough to have money left over. You can then use that money for debt consolidation or keep it in the bank.

Since it is a first time mortgage, a payout refinance typically offers a lower interest rate than a home equity loan or a HELOC. But remember, the interest rate you qualify for applies to your entire mortgage balance, and not just the money you take out of your home.

Whichever method you use to tap into your equity, it’s a good idea to compare the rates and terms you qualify for with different lenders to avoid overpaying.

About the author

Matt Carter

Matt Carter is a credible student loan expert. Analysis pieces he contributed to have been featured by CNBC, CNN Money, USA Today, The New York Times, The Wall Street Journal and The Washington Post.

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