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Home equity is the difference between what you owe on your mortgage and what your home is worth. You gain home equity when you pay off the principal balance on your mortgage and when your home value increases.
You can use equity in your home to pay for home renovations, consolidate other high yield debt, and cover other vital expenses.
Home loans and home equity lines are common ways to develop your home equity. Each has its advantages and disadvantages and carries risks. Here is a quick guide to help you decide when one is more suitable for your needs.
What is a Home Equity Loan?
A home loan, also known as a second mortgage, allows you to keep your existing mortgage but take out a second new loan against the equity of your home in a one-time event. You pay back the loan with the same monthly installments over a fixed term.
You can typically borrow up to 85% of the equity in your home through a home equity loan. For example, if your home is currently worth $ 400,000 and your current mortgage balance is $ 300,000, you have $ 100,000 in equity and could get up to $ 85,000 (85% of $ 100,000) with a home loan .
You can find out about current mortgage rates and learn about another product for generating equity – a cash-out refinance – by visiting Credible.
What is a Home Equity Line of Credit?
A home equity line of credit, or HELOC, is similar to a home equity loan in that you keep your existing mortgage and borrow against the equity of your home. However, HELOCs are revolving loans that allow you to repeatedly withdraw funds up to the credit limit during a term known as the “Draw Period”. You then pay back the loan over a different term, the so-called “repayment period”.
Most lenders limit the amount you can borrow under a HELOC to 85% of the estimated value of your home minus the amount you owe on your existing mortgage. If your home is worth $ 400,000 and your current mortgage balance is $ 300,000, you can have a home line of credit of up to $ 40,000 ($ 400,000 x 85% = $ 340,000 – $ 300,000 = $ 40,000 US dollars).
Home Loans Vs. HELOC: What’s the Difference?
Both home loans and home equity lines allow you to borrow against the value of your home, but there are a few key differences.
Fixed rates vs. floating rates
The interest rates on home loans are usually fixed. So if interest rates rise during the life of your loan, your payments will not be affected.
HELOCs usually have variable interest rates. If interest rates rise, so will the interest rate on your HELOC, and with it your monthly payment.
Payout: lump sum vs. requirement reference
With a home equity loan, you borrow a certain amount in a lump sum and repay the loan in regular monthly installments over a fixed term.
A HELOC gives you more flexibility in terms of the amount you borrow and when. As with a credit card, you have a line of credit that you can use over and over again during the drawing period, and you only pay interest on the amount currently drawn.
Repayment: fixed payment vs. variable monthly payment
For a fixed rate home loan, your monthly payment is based on the total amount of the loan. The term of the loan is usually five to 30 years. During this time, you make equal monthly payments that include both principal and interest.
HELOC payments, on the other hand, can change from month to month. Since most HELOCs have floating rates, your interest rate can fluctuate over the life of the loan. In addition, your payment will be based on the amount you are currently using. For example, if you have a $ 20,000 HELOC but only withdraw $ 10,000, you will only pay interest on the $ 10,000 currently in use.
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Advantages and Disadvantages of Home Loans
Like any loan, home equity loans have advantages and disadvantages. Before you start borrowing against your home’s equity, consider the following:
Benefits of Home Loans
Fixed Rate: One benefit of a home loan is the fixed rate. Even if interest rates go up, your monthly payment will not go up because your interest rate will stay the same.
Flexible use of funds: Lenders typically allow borrowers to use the funds for any purpose. Once approved, you can use a home loan to pay for home improvement projects, debt consolidation, buying an investment, paying education expenses, and other purposes.
Potential Tax Benefits: If you are using a home equity loan to upgrade the property backing the loan, the interest may be tax deductible. Remember, you must list deductions to benefit, and your deduction is limited to interest up to $ 750,000 in debt, including your first mortgage.
Disadvantages of home loan
Two mortgage payments: Unless you have already paid off your first mortgage, when you take out a home loan you will receive a second mortgage payment that you can juggle with every month.
Higher interest rate than a HELOC: you will likely pay a premium to have a stable interest rate. Home equity interest rates are generally higher than the initial rates available on HELOCs.
Closing Costs: As with other home loans, there are closing costs and fees on home loans that average between 2% and 5% of the loan amount. Your lender may be able to incorporate these into your loan so you don’t have to raise cash to close, but they add to your overall borrowing cost.
You can find information on closing costs at Credible, where you can also find out about current mortgage rates.
Advantages and disadvantages of HELOCs
Home equity lines of credit also have advantages and disadvantages. Before tapping into your home equity with a HELOC, consider the following pros and cons:
Advantages of HELOCs
Lower Initial Interest Rate: HELOCs have lower interest rates than a credit card or personal loan, and also typically offer lower initial interest rates than home equity loans. Note, however, that the APR on a HELOC can increase as the interest rates increase.
Borrowing Flexibility and Repayment: You might have a HELOC worth $ 30,000 but only need $ 5,000 this month to replace your oven. Next month, you may need $ 10,000 to repair the roof. With a HELOC, you can use your line of credit as needed and even repay it while you borrow. Each time you use your credit line, your payment will be based on the outstanding amount.
Potential Credit Benefits: The mix of credit types on your credit report is a factor in determining your credit score. Adding a HELOC to your existing loan usage could expand the range of loan types you use – and have a positive impact on your credit score.
Disadvantages of HELOCs
Ongoing Costs: HELOCs have many of the same upfront closing costs as a home loan, but lenders may charge fees throughout the life of the line of credit. According to the FTC, these ongoing charges can include an annual membership or entry fee, as well as a transaction fee for each time you borrow.
Variable interest rate: With a variable interest rate HELOC, your interest rate can rise or fall depending on market fluctuations. Even if your HELOC offers a low starting rate, depending on economic factors, you may face higher rates once you reach the repayment deadline.
Risk of overspending: Managing a HELOC can take some self-discipline as it is very easy to access and spend from a HELOC. If you are not careful, you may run out of your spending limit and face high interest costs at the beginning of the repayment period.
Home Loans Vs. HELOC: Which Is Better?
Which home product is better for you – loan or line of credit – depends on your needs and your specific situation.
If you need a large sum of money for a one-time event and want the stability of a fixed rate of interest, a home equity loan might be the way to go. However, if you want to spread your home equity in smaller increments over several years and you don’t mind uncertainties about your interest rate, a HELOC may be your choice.
When should you bet on home equity – and when not
Whether you opt for a HELOC or a home loan, avoid using your home equity to pay for things that aren’t strictly necessary, such as household expenses. Both home loans and HELOCs use your home as collateral. So, if you run into financial trouble and cannot make your monthly payments, you risk losing your home.
Likewise, it’s a good idea to avoid home equity to cover purchases that are depreciating in value faster than you can pay back the loan. For example, if you are using a 30 year home loan or line of credit to buy a car, the car may need to be replaced in five to ten years. However, you may find yourself paying off the debt you used to buy it for several years.
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What You Should Know About Home Ownership
You may want to tap into your home’s equity for many reasons, but before you apply for a home loan or HELOC, consider how long you plan to stay in your home. If you cannot pay off the loan or line of credit before your sale date, you can walk away with little or no profit on the sale after you have paid off your mortgage and closing costs.
When deciding between a home equity loan or HELOC, you should check out different lenders to compare interest rates and fees. Ask lots of questions to make sure you are getting the right financial product at the best possible price.
Credible can’t help you find a HELOC or home equity loan, but it can help you compare cash-out refinance offers – another option for raising equity.