HELOC vs Home Equity Loan: Pros & Cons, Rates + Does Bad Credit Work?
Equity financing occurs generally through a home equity loan, which functions more as a second mortgage or in the nature of a mortgage, and a home equity line of credit (HELOC). The latter approach is a credit card, but the debt on it is secured by your home.
Which of these approaches you use will depend upon a number of factors, such as your tolerance for interest expenses, your particular needs, and your financial situation. Since a loan against the equity of your home puts your house up as collateral, default on equity loans or lines of credit place you at risk of loss in a foreclosure. These shape some of the pros and cons of using a home equity loan or a home equity line of credit.
Establishing the Equity Financing
To calculate the loan or limit of the line of credit, the lender starts by subtracting your existing loan balances and other debts from a percentage of your equity. The main debts on the home consist of the principal mortgage. Other loans secured by your home will factor into the equation.
An appraisal will fix for the lender the value of the home. As such, you’ll have an appraisal fee as part of the loan or HELOC. So that the lender will have security, you will sign a deed of trust or mortgage that is. recorded in the land records office. Either the lender in house or a lawyer engaged by the lender prepares that document.
Once the lender determines the value of your home, it will then assign a loan-to-value ratio to determine the percentage of equity that can be used for the home equity financing. As a rule of thumb, banks set the loan-to-value ratio at 85 percent.
For example, if you have a home that is worth $200,000, the bank, using a loan-to value-ratio of 85 percent, would set the amount of equity (assuming no other debts against the home) at $170,000. If you had a current mortgage of $100,000, the credit limit on the equity line of credit or the amount of your home equity loan would be $70,000.
The Home Equity Loan
Home equity loans generally serve you best when you have a single purpose or need for the draw and you have reasonable certainty of the cost. In this category often lies debt consolidation efforts, by which you pay your existing credit card debt and personal or other loans with the equity. Debt consolidation with home equity replaces often high-interest credit cards and personal loans with a lower-interest rate, effectively reducing monthly payments. With a debt consolidation, you make only one payment per month on your debts and avoid the need to track However, your home becomes collateral for the consolidated debt, with non-payment or other defaults subjecting the home to foreclosure.
These same principles apply to using a one-time home equity loan to purchase a vehicle. The finance company used by the dealer typically charges higher rates than your bank. With the home equity approach, you get a lower car payment. However, adding debt for a vehicle again raises the specter of foreclosure if you miss payments. A car loan through a finance company relies on the vehicle itself as collateral, so a default in payment (on the car loan) equates to a repossessed vehicle rather than a lost home because of missed payments on a loan secured by the home.
Home equity loans also work well for short-term home improvements. In this group may belong one-time replacements of a floor, HVAC unit or roof. Multi-room or multi-faceted home projects typically do not get funding through one-time home equity loans.
If you’re contemplating a project that entails many rooms or mini-projects, you may take the home equity line of credit routes. HELOCs combine use of your home’s equity as collateral with the flexibility of a credit card. That is, unlike the lump-sum home equity loan, you can draw from the equity multiple times with a HELOC. Such use serves you well for paying several contractors or suppliers.
Having the line of credit helps fund vacations or trips. While you have the travel fare and hotel or other lodging, some of your activities are not planned. The flexibility of a HELOC allows you to access to money for activities requiring continuous outlays. These include college, professional or graduate schools and medical treatments.
The Home Equity Loan Pros
Fixed Rates. Most home equity loans assess interest at a fixed rates. As a result, your payments do not fluctuate. Those payments include a principal and interest component, which means that you will know how fast you pay down the principal if you make the monthly payments. This affords you more ability to plan your budgets and spending when you consider a home equity loan.
Lower Rates. Loans secured by your home or its equity carry lower rates than unsecured loans or credit. The presence of collateral to back your repayment obligation creates the more favorable rates. In a single home equity loan, your interest rate will fall slightly lower than a HELOC because you do not have repeated draws of equity.
Promoting Financial Discipline. A home equity loan results in only one disbursement. This means your decision to tap into equity likely has involved considerable aforethought into the purpose of the loan and your ability to repay it. Home equity loans also are not well suited for repeat draws. Therefore, you’re not as likely to rely upon the equity of your home to meet monthly expenses or to loosen financial pressures you might otherwise feel.
The Home Equity Loan Cons
Little or No Flexibility. The process of getting a home equity loan involves appraisals and title searches. When the loan is ready to close, the bank or its lawyer will prepare a mortgage or deed of trust. These items represent costs to you for access to your home equity.
A home equity loan allows you one draw of money. As a result, you need to have a fairly sound and certain estimate the cost of your project or other funding needs. Otherwise, under estimating necessitates having to repeat this process. Should you need another deed of trust or need to rework the loan, you run the risk that the home will not have as much value. This means you may not get enough to meet current needs.
Less Chance at Tax Breaks. In 2018, Congress suspended until 2026 the interest deduction for home equity loans. The loss of this tax benefit also applies if you go the home equity line of credit route. If you are using the equity for a home improvement or home edition, you still get to deduct the interest on the equity loan or line of credit. Otherwise, equity financing to consolidate debts or purchase a vehicle are still subject to the suspension.
However, tapping into home equity can still provide tax breaks if you use the proceeds in connection with your business. This is because the interest you pay on a home equity loan can be claimed as a business expense on Schedule C of your Form 1040 income taxes, rather than as an interest deduction on Schedule A, if you operate as a self-employed, sole owner of a business.
As a practical matter, the benefit of deducting interest as a business expense is less likely in a single home equity loan. Your business may encounter the need for investing and equipment, land or other assets. You are more likely to have recurring needs for financing, especially in the early months and years of your business. Since you may find yourself less likely to use a home equity loan in business financing, you are less likely to have interest expenses that you can deduct as business expenses.
Less Value Realization. Thanks to the one shot nature of a home equity loan, your loan balance tends to run higher than with a home equity line of credit. In turn, these loans usually take longer to repay. A longer loan term means there is more time and opportunity for events which can reduce the value of your home and, thus, your equity. Should you sell the home, you have the home equity loan and perhaps your principal mortgage to pay from the proceeds of the property sale.
Home equity lines of credit usually allow you smaller draws and, consequently, lower balances. In other words, you are committing less of your equity to the repayment of debt. If you sell your home, you conceivably have less debt to repay out of the sale price and you keep more of equity.
The HELOC Pros
Flexibility of Draws. Unlike the home equity loan, a home equity line of credit does not limit you to one draw. You need not have to anticipate all of your costs, expenses or needs at a single time. You don’t need an appraisal, document preparation or other items every time you need to summon your home equity.
Payment Options. Lenders afford interest only payments (for a period) and the more traditional principal and interest payment approaches. With interest-only comes smaller monthly payments, but the latter payment option provides a quicker path to paying off the balance.
In HELOC loans, the time to pay off the balance begins when your access to the line of credit ends. The terms of the HELOC agreement define this repayment period, but can run as much as 20 years.
The HELOC Cons
Variable Interest Rates. On the whole, home equity lines of credit carry variable interest rates. An index for a prime interest rate or other rate at various points in time sets the interest rate for the HELOC. Your monthly payments may fluctuate, causing sometimes higher than expected payments. Some lenders offer fixed-rate home equity lines of credit or hybrids of them.
With the moving rates and changing payments come challenges in your budgeting or financial planning. To meet the lack of certainty in knowing the payments to be made, take advantage of the ability to draw smaller amounts via the HELOC.
Temptation to Spend Too Much. The relative ease with which you can borrow equity through a HELOC raises the potential of financial irresponsibility. If you lack discipline or sense yourself facing a financial pinch, you might use the credit for monthly expenses or to finance purchases that you really may not need. These are the same temptations and potential pitfalls associated with using credit cards. Unlike the traditional credit cards, overuse or mismanagement of a HELOC could cost you the home in a foreclosure proceeding.
Other Considerations for Home Equity Financing
Under one school of thought, you should only borrow against your equity to grow the value of your home. These would include activities such as roof replacement, additions to the home, landscaping projects, and new flooring or carpet. When you use home equity to buy vehicles, you are using your home to finance assets that depreciate.
Depending on your financial situation, turning to home equity can rescue you from higher interest payments and earnings. Should you owe on a principal mortgage, relief from the higher payments might save you from a foreclosure by the principal mortgage holder.
However, you might think about not consolidating unsecured debt because keeping your debt unsecured makes it more difficult for a creditor to take your home. Should you become unable to pay a regular credit card, that creditor may get a judgment against you. In most states, you can exempt a certain amount of your property from being taken, sold and applied to the judgment. These exemptions include one for your principal residence, or homestead. The amount of the exemption consists of the equity in your home, that is, the total value less mortgages or other debts on it. In some cases, debtors have equity less than the maximum amount that may be claimed. If you’re in that camp, you could protect all of the equity from a judgment. By contrast, a lender for your home equity loan or line of credit can foreclose if you miss payments. The exemptions do not avail you.
Keep your financial condition and your goals and needs in mind if you plunge into equity financing. These factors will guide you in whether to go the home equity loan or home equity line of credit approach.
The difference between a Home Equity Loan and a Home Equity Line of Credit can help not only pay off debts, but can add a substantial amount of money in your pocket. However, most homeowners are unsure of what the difference is between a home equity loan and a home equity line of credit. Hopefully the following FAQ’s will help you understand the difference between the two as well as learn which option is best for you.
General Home Equity Loan FAQ
In this section, you will find frequently asked questions regarding general home equity loans such as what a home equity loan is to how many loans you can take out at once.
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What is a home equity loan?
A home equity loan is a loan that allows you to borrow against the value of your home over the amount of any mortgages you have against the property. These types of loans are easier to qualify for.
How does a home equity loan work?
A home equity loan works differently than traditional loans. An equity loan means that the bank approves to borrow a certain amount of equity from your home and the equity stands as collateral for the loan.
How to get a home equity loan?
The best way to get a home equity loan is to go through the same bank that you received your mortgage from. A home equity loan is a type of second mortgage, which can be borrowed from the same bank and placed on the same account.
Can you use a home equity loan for anything?
A home equity loan can be used for anything, even if it is not used for home related expenses. Whether that is to pay back a credit card bill, fix the roof of your house or pay your student loan, your loan is yours to do what you will.
How to qualify for a home equity loan?
There are a few steps you need to take to make sure you qualify for a home equity loan. First you need to make sure you have equity in your home. Then determine what your loan-to-value ratio is, determine what your monthly income for the loan is, find the market value of your home, take into account your credit history and determine your ability to repay your loan.
Can I use a home equity loan to buy another house?
In order to purchase a second property with a home equity loan, you need to make sure you have substantial equity in your current home, upwards of 85% of the value of your current home.
Can you have multiple home equity loans?
Yes, while you can have multiple home equity loans, it is a very rare occurrence. In order to have multiple home equity loans, you need to have substantial equity in your home and have excellent credit.
What is better, a home equity loan or a line of credit?
If you have to choose between a home equity loan or a line of credit, the best option is to have a home equity loan. Not only do these types of loan have lower interest rates, but they can have as low as a 3% APR as well.
How hard is it to get a home equity loan?
A home equity loan is much easier to qualify for than it is to qualify for a personal loan. All you need is to have existing equity in your property and have a credit score of 620 or higher.
Does home equity loan require appraisal?
This depends on how long it has been since your initial appraisal with your mortgage lender. If you have a mortgage that is less than six months old, then your lender will use the existing appraisal to calculate the sum of your home equity loan.
Is a home equity loan a mortgage?
While a home equity loan isn’t a traditional mortgage, it can be seen as a second mortgage in a sense. While you need to have good credit as you would for a mortgage, you need to have existing equity in your home as well.
Does Capital One offer home equity loans?
Capital One offers both home equity loans and equity lines of credit. The minimum loan amount for a home equity loan through Capital One is $10,000 with a fixed rate over 5 years.
Does Quicken loans do home equity loans?
Unfortunately Quicken loans does not offer home equity loans. However, Quicken loans does offer a Home Loan Expert that can help you step in the right direction to achieve your future financial goals.
Can you use a home equity loan for a downpayment?
Yes, you can use a home equity loan for a down payment. When you use a home equity loan for this purpose, the idea is to pay it off completely once you sell the property.
What happens if you stop paying a home equity loan?
If you stop paying on your home equity loan through a second lender, the first lender has the right to foreclose on the mortgage on your home and begin foreclosure proceedings which can lead to the selling of your home.
Home Equity Loan Financial FAQ
This section covers all of the financial aspects of home equity loans from interest rates, tax deductions to how to calculate a home equity loan.
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Is a home equity loan interest tax deductible?
If a home equity loan is deductible, it is ultimately up to the IRS. This depends on what the equity loan is used for. If it is used to do work on your home, then you can deduct interest. However, if you use the loan for anything other than your home, then it is not deductible.
How much of a home equity loan can I get?
The amount you can receive from a home equity loan ultimately depends on the value of your home. This is based on a loan-to-value ratio and how much of a share of your home you actually own.
How do you calculate a home equity loan?
To calculate a potential home equity loan is to take into account your loan-to-value ratio. Take that balance of your loan, which can be found on your monthly statement and divide by the appraisal number of your home.
Can I get a home equity loan with bad credit?
Typically, most lenders will require you to have between a good and excellent credit history in order to qualify for a home equity loan. You should have a credit score of 620 or higher is you want to qualify for equity.
Can you refinance a home equity loan?
Yes, you can refinance a home equity loan with a new home equity loan. This is a great option to refinance your current mortgage for a lower rate or to set different terms of your current loan.
Are there closing costs on a home equity loan?
Any closing costs or closing fees associated with a home equity loan will vary from lender to lender. Most lenders that do charge closing fees, can roll the closing costs into the loan amount so you don’t have to pay anything upfront.
How to get a home equity loan with low income?
Yes, you can get a home equity loan with low income. Home Equity loans have two forms that you can qualify for if you have low income: HECM saver and HECM standard.
How to get a home equity loan with no equity?
While you do need equity on your home in order to qualify for a home equity loan, some homeowners may not have equity. There are other loans that you can take out instead such as a personal loan or a Title I property improvement loan.
What is the interest rate on a home equity loan?
The interest rate on a home equity loan will vary by lender. However, it is not uncommon to find interest rates that vary from 3% APR to 5.49% APR for a 10-year home equity loan.
Which bank has the best home equity loan rates?
The best home equity loan lenders with the best home equity loan rates are USBank, PenFed Credit Union, CitiMortgage, Navy Federal Credit Union, BB & T Home Mortgage, Flagstar Bank and Loan Depot.
General Home Equity Line of Credit FAQ
This section covers all of the basic information regarding home equity lines of credit that you need to know to answer basic questions to getting a home equity line of credit.
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What is a home equity line of credit?
A HELOC or home equity line of credit is a line of credit that helps secure your home by giving you a revolving line of credit that can be used for large expenses or to help consolidate high interest rate debts from other loans.
How does a home equity line of credit work?
A home equity line of credit works differently than a home equity loan by focusing on a line of credit that doesn’t need to be used entirely. A borrower can borrow as much as needed.
How to get a home equity line of credit?
The best way to get a home equity line of credit is to visit the bank or lender you receive a mortgage for your home from. There you can apply for the line of credit with the amount you need.
How to apply for a home equity line of credit?
There are many steps to follow when applying for an equity line of credit:
- Check your credit score and make sure it Is about 650.
- Check the available equity of your home.
- Check your current debt.
- Apply through a lender or bank.
Is a home equity line of credit a good idea?
This ultimately depends on your financial needs. While a home equity line of credit can help you fix minor issues around your home, it may not be a worthwhile investment if you are already in debt.
How to qualify for a home equity line of credit?
In order to qualify for a home equity line of credit, you must have at least 15% to 20% equity on your home, a debt-to-income ratio of 43% and a credit score of 620 or higher.
What is a co-op home equity line of credit?
A co-op home equity line of credit is an equity line of credit that can be used on a co-op home instead of a traditional family home. The process to applying for this kind of loan is slightly more complicated than applying for a traditional home equity line of credit.
What to know about home equity line of credit?
The important thing to know about a home equity line of credit is that it works similar to a credit card. It allows borrowers to borrow money from the equity in their home to use as they will.
Do home equity lines of credit expire?
Home equity lines of credit only expire after the contractual time made between the lender and the borrower. This is located in the home equity line of credit contract you sign prior to receiving the funds.
How long to pay off a home equity line of credit?
The term for a home equity line of credit typically has a 25-year term payment period, which also allows a draw period within the first 5 years to 10 years.
Can you have 2 home equity lines of credit?
While it is possible to have multiple home equity lines of credit, it is rare in most instances but there are a few lenders out there that will offer multiple lines of credit.
Does Quicken loans do home equity lines of credit?
No. Unfortunately Quicken loans does not currently offer home equity lines of credit to borrowers. However, Quicken loans will pair up interested borrows with a home loan expert to help them meet their financial goals.
How do banks calculate home equity line of credit?
Banks calculate home equity lines of credit by determining your loan-to-value ratio and dividing that number by your current loan balance. The bank will also take into account your bill payment history and credit score.
Does USAA offer a home equity line of credit?
No. Unfortunately USAA no longer offers home equity lines of credit. However, USAA does offer home equity loans which you can apply for directly by visiting the official USAA website here.
Home Equity Line of Credit Financial FAQ
In this section, you will discover every financial frequently asked question pertaining to home equity lines of credit from tax deductions to refinancing questions.
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Is home equity line of credit interest tax deductible?
Yes. According to the IRS website, it will allow interest tax deductions on home equity lines of credit for up t0 $100,000, regardless of what you spend the money on.
How to calculate a home equity line of credit payment?
Most lenders will calculate home equity lines of credit payment for you, but you can calculate it yourself by dividing the overall loan amount, interest rate, interest period and the repayment period.
Can a home equity line of credit be refinanced?
Yes, you can refinance a home equity line of credit. When you refinance your line of credit, you start off with a new home equity line of credit with its only interest only draw period.
How does a home equity line of credit affect credit score?
A home equity line of credit is reported as either a mortgage or an installment loan on your credit report. Because of this, it can affect your credit history just like any credit card would.
Is a home equity line of credit secured or unsecured?
A home equity line of credit is considered to be a secured credit line because you must use existing equity from your home to secure the loan. Failure to repay your home equity line of credit can cause your home to be foreclosed on.
How much home equity line of credit can I afford?
This is a question that only you can ultimately answer. Take into account your current debts and your monthly income to see if you can afford to take on another debt.
What is the best home equity line of credit rate?
The best home equality line of credit rate to aim for a 3% to 5% rate. However, keep in mind most home equity line of credit lenders often offers lines of credit that range from 5% to 8% in rates.
Can I increase my home equity line of credit?
Most lenders will allow borrowers to apply for an increase in their home equity line of credit other than refinance a new line of credit. While the increase in the line of credit affects the available credit, it does not lengthen the terms of the original loan.
How to settle my home equity line of credit?
In order to settle a home equity line of credit, it is best if you contact the lender and negotiate a lump-sum settlement of the line of credit. You can even opt into a payment plan.
Can you transfer a home equity line of credit?
Yes. Most lenders allow you to transfer a home equity line of credit. In order to do so, you will be asked to apply for a new home equity line of credit and you can transfer your existing balance to this new line of credit.
Does a home equity line of credit affect pmi?
Yes. A home equity line of credit can affect pmi since borrowers have to pay a pmi when less than 20% is paid in a down payment on a home. By using a home equity line of credit to put even more on a down payment, you can avoid paying a pmi fee in the process.
Jordan's work focuses on helping people reach their financial goals so they can spend more time with family and friends and less time worrying about their budget. After finishing college with a degree in Accounting and Communication, he realized that these are the most important things in life and that people shouldn’t miss out because of money.