If you need a quick cash injection and own sizeable equity in your home, equity loans can help. Home equity loans and home equity lines of credit are low-interest rate loans taken out against your home. Also known as second mortgages, they allow homeowners to tap into their equity, and offer a plethora of benefits, as well as a few downsides.
But which option is best for you and your needs, how do they differ, and what can they be used for?
Home Equity Loan vs Home Equity Line of Credit
Home equity loans and lines of credit are types of second mortgages, which means they often exist in addition to your primary mortgage. They are secured against the equity that you own, and the size of that equity will dictate how much you’re offered and what sort of rate you’re provided with.
A home equity loan gives you a lump-sum payment in exchange for securing your equity. A home equity line of equity, also known simply as a HELOC, is a line of credit that works a lot like a credit card.
In both cases, you are not selling your home or any part of it. You’ll still technically own all the equity that you secure against the loan, but if you ever default on it then the lender may seek to initiate foreclosure.
Of course, because they are second mortgages, the primary lender will take priority in the event of a complete mortgage default, but once they have secured their share then the second mortgage lender will take theirs.
Home Equity Loan Details
- Payment Type: Cash paid upfront
- Interest Rate: Fixed-rate of interest
- Interest Charges: Pay interest on the entire balance
- Closing Costs and Fees: Closing costs and fees charged
- Repayment: Fixed monthly payments that never change
Home Equity Line of Credit Details (HELOC)
- Payment Type: Money paid as a line of credit during a draw period
- Interest Rate: Variable interest rate.
- Interest Charges: Only pay on what you withdraw from the credit line
- Closing Costs and Fees: Closing costs and fees tend to be lower
- Repayment: Interest-only payments possible
When to Consider a Home Equity Loan
Towards the end of this article, we’ll discuss some of the ways you can use a home equity loan or HELOC, covering both the positive and the negative. But for now, it’s important to understand which of these options is best for you based on your current situation.
A home equity loan may be the better option if:
You Need A Lot of Money Now
The main reason to opt for a home equity loan is if you need a lot of money and you need it sooner rather than later. This is generally the better option is you have a specific amount in mind, such as if you have a vacation planned or medical bills to pay and have been given a specific quote.
That way, you know how much to borrow and can use the money straightaway, before focusing on making repayments.
It gives you some clarity and certainty, as you’ll be told how big your monthly payments will be, how long they will last, and how much money you’ll get in return for your home’s equity.
It’s important to take a little as possible, but to make sure you have more than you need. That seems like a contradictory statement, but for example, if you are planning a cruise around the Mediterranean and have been quoted $15,000 for you and your family, you should consider taking $20,000 instead.
That way, you’ll be covered for spending money and unforeseen expenses and won’t need to resort to taking out personal loans, cashing savings or putting everything on your credit card when you realize you’re short.
You Want a Fixed Interest Rate
A home equity loan will typically cost you much less than a HELOC over the life of the loan. It also charges a fixed monthly amount, one that doesn’t change regardless of the prime rate and your accumulated equity.
Understanding how much you will be expected to pay over the loan term can help you to prepare and keep nasty surprises at bay.
You Have Debt to Repay
One of the best uses of a home equity loan is debt consolidation, whereby you use the loan to pay off your current debt. If you have a lot of debt tied up in credit card balances and personal loans, chances are you’re paying a much higher rate of interest than with a home equity loan.
Therefore, by swapping one big secured, low-interest debt for lots of small, unsecured, high-interest debts, you could pay much less interest over the loan term.
Calculate how much debt you have; how much it is costing you every month (and over the term) and make sure you consider prepayment penalties as well. You can then calculate the same projected costs for a home equity loan and will likely discover that the latter will save you thousands when used to clear your debt.
Of course, for this to work, the home equity loan needs to provide you with a sufficient amount of money to cover all of your existing debts, which is reliant on your home’s value and your loan-to-value ratio.
When to Consider a HELOC
On the surface, a HELOC can seem like a better option. The loan amount isn’t as high and the money is released over a period of time, as opposed to a single lump-sum. But that could provide some huge benefits for certain types of homeowners.
You Don’t Know How Much You Will Need
If you have a couple of big events coming up, such as a wedding and honeymoon, and you don’t know how much money will be needed, a HELOC may be the better option. With a HELOC, you can draw money as you need it, paying interest only on the amount that you draw.
You will typically be charged a higher interest rate for this type of loan, but it means you can use the money to make staggered payments, such as a debt clearance this month, a wedding in a few months, and a vacation at the end of the year.
Your Income Rises and Falls
If you’re self-employed and don’t have a consistent or reliable income, a HELOC may be better than a home equity loan. With a lump-sum loan, the money typically goes quickly and then, if you encounter a slow period at work or you’re hit with a major bill, you don’t have many options for repayment.
But if you have a HELOC, you also have a line of credit waiting for you, one that can get you out of trouble when you need it.
Pros and Cons of a Home Equity Loan
- Pro = Large cash lump-sum (based on home value) to spend as you please.
- Pro = A fixed interest rate is charged.
- Pro = The repayment period and the monthly payment is fixed and remain the same.
- Cons = Interest payments may be higher than your first mortgage.
- Cons = Your home equity is at risk.
Pros and Cons of a Home Equity Line of Credit
- Pro = Interest is only charged on the amount you withdraw.
- Pro = Borrow money as and when you need it during the draw period.
- Pro = Can be used to make multiple small payments.
- Pro = Large credit limit, depending on the value of your home and the size of your equity.
- Cons = Only offered by credit unions and traditional banks.
- Cons = Your home equity is at risk.
- Cons = Interest rate is variable, and the loan is open ended, making it difficult to judge how much you will pay over the life of the loan.
How to Use Home Equity Home Loans
There are many reasons you may want to consider a home equity loan or a HELOC, some more preferable to others, but all viable and all allowed. In fact, as long as you have the equity and meet your payments on time, the lender won’t care how you spend the money.
College tuition is expensive and student loans don’t always cover everything that you need, especially if you’re studying for an advanced degree or you’re a mature student.
You need to think about living expenses as well as college tuition fees and equipment, and a HELOC or revolving line of credit can provide you with more options, more variety, and potentially a lower rate.
Major expenses like funerals and medical bills can arise unexpectedly and hit you hard, taking savings or leaving you with few options. If you have a significant share in your own home, however, then a home equity loan could help.
These loans can give you a cash sum to be used on everything from weddings to funerals and medical bills, helping you to dig yourself out of trouble.
Spending your home equity loans or credit on a vacation is risky, as you’re using a secured expense tied to your most important asset to purchase something that is fleeting and won’t give you any tangible assets.
However, we all need to live a little and while vacations can’t pay you interest or dividends and won’t appreciate in time, they will give you memories that last for a lifetime and allow you to place one extra tick on your bucket list.
One of the most common uses for equity loans is to remodel, renovate or complete a major home improvement project. The costs of this project may be tax-deductible and could help to significantly boost the market value of your home.
As discussed already, this is probably the best way that you can use a home equity loan as it’s one of the few options (along with home renovation) that may actually result in you saving/gaining money over the long term due to the lower interest rate offered by these loans when compared to unsecured debts.
Home equity loans are ideal if you have some equity in your home and need some fast and easy cash. However, simply having a house isn’t enough to get these types of loans.
Your debt-to-income ratio and credit score will both be considered to make sure you can afford to meet the repayment schedule. And even if you do qualify, they may not be the best options available to you.
You can also look into a cash-out refinance, which gives you a larger mortgage than you need and lets you collect the remaining cash, or a reverse mortgage, which is only available to older homeowners who control a large equity stake.
In any case, the more of your house that you own, the more loan options you have and the better the rates and fees will become. So, if you get rejected, keep building that equity and try again in a few years.