Here we discuss the difference between a HELOC and Home Equity Loan. The terms HELOC and Home Equity Loan are defined and explained in detail. Finally, a comparison is conducted determine which is best for you.
If you have lived in your home more than 5 years, you’ve probably seen your home value skyrocket. Home prices in the United States have gone up significantly in the past 5-10 years. Some analysts are saying that we may be in a Real Estate bubble.
According to the National Association of Realtors, the median price of a single family home in the United States increased 4.2% in the 2nd Quarter of 2020. This is a trend that been ongoing for some time, and even the Pandemic has hardly slowed demand for homes.
Home Equity Loans vs. Home Equity Line of Credit (HELOC)
There are two primary ways to tap into the value of your home. Home Equity Loans and Home Equity Line of Credit (HELOC). Both of these financial instruments allow you to use your home as collateral to access money for different reasons.
Why Tap into Home Equity
Reasons to Tap Into Home Equity Include Emergencies, Renovations, Vacations, Debt Payment and College Expenses
There are many reasons why individuals tap into the equity in their home. Some examples of situations where home owners need the money that is in home equity include:
- Personal Emergencies
- Home Repair/Renovations
- Debt Consolidation
- College Education Expenses
Home Equity Loan (Equity Loan)
A Fixed Rate Loan Based on the Equity in Your Home
A home equity loan is simply a secured loan that is based on the equity that you have in your home. For example, if your home is worth $250,000 and you owe $150,000 on your home (your mortgage balance), then you have approximately $100,000 in equity in your home. Normally, a home equity loan is a fixed rate loan, like your mortgage.
These are known by different names, such as:
- Home Equity Loan
- Equity Loan
- Home Equity Installment Loan
- Second Mortgage
Equity Loans allow you to borrow up to 80%-90% of the home value (less what is owed). In addition, repayment terms can range from 1-20 years. It’s also important to note that the terms of your loan and your interest rate are based upon your credit score. In addition, home equity loans are paid out in one lump sum payment. The lender considers the following things: credit score, income and payment history.
Loan Amount Eligibility
Banks and lenders determine how much they can lend to individuals based upon several factors. Those factors include:
- Combined Loan-to-Value Ratio (CLTV)
- Credit Score
- Payment History
Most of these factors are pretty straight forward. But Let’s look at combined loan-to-value (CLTV) ratio. Lenders commonly use a CLTV ratio of approximately 80%. For example, if your home is valued at $200,000 and you currently owe $75,000 on the home, then they may lend you up to $85,000 (math is below).
CLTV calculation ratio amount: $200,000 X .80 = $160,000
(CLTV amount – what you owe) $160,000 – $75,000 = $85,000
Home Equity Loan Downsides
Some Disadvantages to Home Equity Loans Include Closing Fees and Larger Loan Amounts
One disadvantage to a home equity loan is that you may have to pay closing costs on the loan, much like a traditional home mortgage. Furthermore, fees associated with the loan may include origination fees, recording fees, appraisal fees and loan processing fees.
Another downside to equity loans is that many lenders don’t want to lend small sums, such as $10,000. Additionally, in some cases, lenders won’t lend less than $25,000. Furthermore, if you want to tap into a smaller amount of your equity, then a home equity loan may not be the solution for you.
Home Equity Line of Credit (HELOC)
A variable rate line of credit accessible when you need it
A Home Equity Line of Credit or HELOC is not the same as a loan. Instead, it is a line of credit (kind of like a credit card). This is called a revolving source of funds. HELOCs typically have variable interest rates, instead of fixed interest rates, which can be a serious matter. So do your research before you sign.
These types of loans are frequently used as an emergency source of money. They normally don’t incur closing costs like you might encounter in a normal mortgage. In addition, funds can be easily accessed and withdrawn from the HELOC.
HELOCs allow the borrower to withdraw money on an as-needed-basis from their credit line. However, the borrower must stay up to date on interest payments to maintain access to the credit line.
Normally, a HELOC is divided into two terms. During the first term, you can withdraw money. During withdrawal, you make payments on the interest that is accrued. Additionally, the term can last for a designated number of years, depending on the terms of your contract. Next, once you have completed the withdrawal period, the second term of the HELOC starts. This is when you actually make payments on the credit you have withdrawn. These payments are larger than what you paid during the first term.
A Word of Warning
There are inherent risks with borrowing and debt must be repaid
It’s important to understand the potential repercussions of these financial instruments. Borrowing money is always risky business, whether it’s through a credit card, loan or line of credit. Sometimes accepting the money seems harmless. Furthermore, you may be exacerbating your financial problems by taking on more debt. Note that debt must be paid back, including interest.
In addition, understand that taking on a second mortgage puts an additional lien on your home and gives the bank a claim to your home. In the event that you are unable to make your payments, the bank can foreclose on your home. The more that you borrow against your home, the more financial risk and stress you take on.
Interest Rates on HELOCs
Interest Rates for HELOCs can vary and Can Move Up or Down; Credit Could Be Frozen
In General, interest rates vary for HELOCs. Normally, the interest rate is determined based on your credit score, payment history and the borrow amount. For the year 2020, rates may vary from 3-20%. However, you should remember that HELOC rates are variable interest rates and can move up or down, depending on market rates.
There is one other consideration to remember regarding HELOCs. If your home value decreases, the lender or bank can freeze your credit access.
Questions to Ask Before Borrowing
There are some important questions that you should answer prior to borrowing money. For example, questions you should have a solid answer for include:
- What will I use the money for?
- Do I need one lump sum or an available credit line?
- What is the purpose of my loan?
- Does fixed or variable interest matter?
- How will I pay back the money?
- Is there a chance that my income will change in the future?
Final Thoughts on HELOCs and Home Equity Loans
We’ve put together a comparison chart so you can visualize the difference between a HELOC and Home Equity Loan. By answering the questions above and using our comparison chart, you can determine which is best for your situation.
Comparison of Home Equity Loans vs. HELOCs
|HELOC||Home Equity Loan|
|Funds Payout||As Needed||One Lump Sum Payment|
|Repayment Schedule||Pay Interest, Then Larger Payments||Monthly Payments Remain Constant|
|Interest Rate||Adjustable Rate||Fixed Rate|
|Closing Costs||Less Than Traditional Loan||2-5% of Loan|
|Best Fit||Longer Term Access to Cash||Larger, One-time Cash Infusion|
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Disclaimer: It is important to note that Piggy Bank Coins does not provide financial advice. We do not endorse or recommend any financial investments. Instead, we provide information for educational purposes to those seeking knowledge regarding personal finance. However, in the spirit of transparency, note that the author is an investor in cryptocurrencies, precious metals, and some equities.
In addition, The Federal Trade Commission (FTC) requires that Piggy Bank Coins disclose to readers that we may receive commissions when you click our links and make purchases. However, this does not impact our reviews and comparisons. Moreover, we try our best to keep things fair and balanced, to help you make the best choice for you.