Contributing Writer at Tally
July 24, 2020
If you own a home, it’s possible to capture some of the value your home has gained while paying your mortgage.
Home values typically change over time. The median price of a home in the United States in 2000 was $119,600. In 2017, the median price was $199,200. Numerous factors can contribute to this increase in value, including housing demands, inflation and home improvement projects you complete.
However, you can capitalize on your home’s increase in value without selling it. Lenders allow you to borrow against the value of your home, using your home as collateral. There are two ways to do so: a home equity loan or a home equity line of credit (HELOC).
We'll take you through the differences between a home equity loan vs. line of credit so you can understand if these lending options meet your needs and, if so, which one is right for you.
A home equity loan is a loan option that's secured against the value of your home. These loans offer competitive fixed interest rates. The home equity loan is a second mortgage, in that you make home equity payments in addition to your first mortgage payment.
You can use the money from a home equity loan for anything you wish, from renovations to medical expenses. Financial experts recommend that you use these funds for larger, ongoing expenses or emergencies, as opposed to short-term splurges.
The biggest benefit of home equity loans is that they are fixed-rate. You receive a lump sum upfront and know exactly how much you need to pay each month. The monthly payment amounts and repayment terms don't change, making it easy to work into your monthly budget.
If interest rates were to fall, refinancing is an option. Interest rates offered by lenders rise and fall based on the federal funds rate, which is “the interest banks charge each other for overnight loans to meet reserve requirements.” The Federal Reserve sets the federal funds rate.
In this case, working with a lender to refinance your home equity loan could yield lower interest rates. The outstanding loan amount would remain the same, but your interest payments would be lower.
The biggest downside of a home equity loan is the risk of using your home as collateral. If you were ever to default on your home equity loan, the bank could foreclose on your home.
This is also the case for your first mortgage as well. If you default on your original mortgage, the bank could foreclose on your home. This means that you need to make two loan payments per month, risking your home if you were to miss either payment.
The other negative of a home equity loan is that it will come with steep closing costs, typically between 2% and 5% of the loan amount. Home equity loans also often come with early termination fees. If you pay off the loan ahead of time, the bank will charge you a prepayment penalty.
A home equity line of credit, otherwise known as a HELOC, is another financial tool that allows you to borrow against your home's equity. Whereas a home equity loan provides a lump sum and a defined loan term, a HELOC operates more like a credit card.
You can take what you need when you need it. You have a credit limit, which is a predefined maximum amount that you can borrow, but you're not required to borrow any of it — again just like how you're not required to make any charges on a credit card.
If you do borrow on your line of credit, you need to pay it back in a certain period of time. If you don’t, you owe interest. With a HELOC, those time periods are known as draw and repayment periods.
The draw period is the time during which you’re allowed to borrow on your line of credit. This term is predefined by your bank when you open your HELOC, but the average is 10 years.
The repayment period is the time that follows the draw period. During this time, you have to repay what you borrowed, and you won't be able to take out any additional funds. The repayment period lasts 10 to 20 years on average.
Typically, you only need to pay interest during the draw period. During the repayment period, you pay both interest and principle on a set repayment schedule.
A HELOC has a variable interest rate, as opposed to the fixed interest rate that comes with home equity loans. The variable rates are typically lower than the fixed interest rate of a home equity loan — at least to start.
But variable interest rates can fluctuate, rising and falling with the federal funds rate. As a result, the interest you accrue could start out at 4% but rise to 10% later in the life of the loan. Some lenders will allow a portion of your HELOC to have a fixed rate, although this depends both on your lender and your credit score.
Like home equity loans, you can use the money from your HELOC as you wish. However, many people use them for things like education expenses, medical expenses or remodels — investments that are more long-term.
A HELOC can be an attractive option because you only draw what you need. You aren't stuck making monthly payments over the course of a few years because you only borrow and pay what you need when you need it.
Additionally, some lenders only require interest payments during the draw period. The draw period is the pre-allotted amount of time that you have to withdraw funds from your HELOC. Draw periods vary by lenders but can last up to 10 years.
Once you start borrowing, a HELOC is tougher to prepare for financially because of the variable interest rate. If the rate were to increase unexpectedly and you miss payments, you risk foreclosure on your home.
If you don't practice financial discipline, it will also be easy to overspend with a HELOC. Much like credit cards, it can be tempting to spend money that's available on your credit line without considering the repayment. If you overspend, you can drain the equity on your home while burdening yourself with hefty principal and interest payments during the repayment period.
Both home equity loans and HELOCs act as second mortgages, drawing on your home's equity. To determine your home's equity, you need to determine the amount you owe on all loans secured by your home — meaning your home is collateral on the loan. Examples of the types of loan to include are:
Secured personal loans
Secured vehicle loans
Once you've calculated this number, subtract it from your home's market value. You need to have your home appraised to determine its market value.
Let's say that you owe $200,000 on your first mortgage and have not taken out any other home loans. The current appraised value of your home is $450,000.
Subtract $200,000 from $450,000. This gives you your home equity, which is $250,000.
If your home was appraised at a value lower than what you owe on your mortgage, then your home's value is negative. This means you owe more than the home is worth and that you do not have any equity in your home.
Like the previous example, let’s say that you owe $200,000 on your first mortgage and have not taken out any other home loans. However, now the appraised value of your home is $150,000.
Subtract $200,000 from $150,000 and you get an equity of –$50,000. You own more on your mortgage than your home is worth.
Because you owe more in debt than the value of your home, you will not have any equity and will not be eligible for a home equity loan or HELOC.
You also need to consider your loan-to-value (LTV) ratio, which is another tool that lenders use to measure your financial situation.
The loan-to-value ratio divides what you owe on your home loans by the appraised value of your home.
Using our first example where your home has positive equity, $200,000 divided by $450,000 is 0.44.
This means that your loan-to-value ratio is 44%.
Lenders typically won't authorize loans to those with an LTV ratio greater than 80% without stipulations, as they are considered high-risk. The higher your LTV ratio, the higher the interest rate you likely need to pay on your loan. One of the most common stipulations if your LTV is above 80% is that you secure private mortgage insurance (PMI).
It's possible that you may not be able to borrow against your home for various reasons, including:
You owe too much on your home
You have a high LTV on your first mortgage, perhaps from having to pay PMI
You carry a lot of debt
You have a poor credit score
If you fall into one of these categories, there may be alternatives to home equity loans and HELOCs. For instance, you can consider a revolving line of credit. Each time you pay off the balance on a revolving credit line, you have access to the full amount again, much like a credit card.
Tally uses a revolving line of credit to help you manage credit card debt and consolidate payments. You can combine all your credit cards into a single monthly payment. All you need to do is pay back Tally once per month.
Depending on why you’re interested in a home equity loan or HELOC, Tally’s debt consolidation method could reduce the amount that you pay in interest debt, saving you money in the long term and helping you avoid credit card fees. It could also allow you to pay off your debts more quickly, boosting your credit score and freeing up funds for other uses.
If you own a home and have a good bit of equity in it, home equity loans and lines of credit could be viable financing options. However, you need to be mindful when choosing either of these lending options, as it means putting your home up as collateral.
If you need a large sum of money upfront and can afford to make steady payments each month, you'll want to consider a home equity loan. If you need a bit more flexibility in when and how much you borrow and would like to start your loan with a low interest rate, you'll want to look into a line of credit.
Also, remember that there are other lending options for those who do not have enough home equity available for either a home equity loan or line of credit.