Since the housing market took a substantial hit in 2008 and 2009, home prices have slowly come back to pre-recession levels and beyond throughout the country. For homeowners who have been in the same property for several years, particularly during this time of economic growth, home equity may have accumulated to a hefty asset.
Home equity is the difference between the market value of a home and the remaining mortgage balance. This amount, in many cases, can be tapped into for a variety of financial needs. Whether it is helping pay for a considerable expense like school tuition or a vacation, or covering the cost of a renovation or remodel, home equity is a valuable tool.
Some homeowners may also utilize the equity in their home for debt consolidation, given the comparatively lower interest rates on home equity lending products. But how do you get the equity out of your home? Generally, home equity loans and home equity lines of credit are the two most common options for accessing this asset.
Breaking Down Home Equity Options
Many homeowners ponder whether a home equity loan or a home equity line of credit (HELOC) is a better choice for their needs. Answering that question begins with understanding the difference between the two.
Home Equity Loans
A home equity loan, sometimes referred to as a second mortgage, is a fixed loan provided by a mortgage lender to the homeowner based on the available equity in a property. For instance, if your house is worth $200,000 and your current mortgage balance is $100,000, you have $100,000 in equity.
A lender may give you up to a certain percentage of that available equity as a loan. You receive the lump sum payment and can use it for whatever purpose you’d like. Over time, however, you repay the home equity loan through fixed monthly payments of principal and interest.
Home Equity Lines of Credit
As an alternative to a home equity loan, some homeowners may opt for a home equity line of credit, also known as a HELOC. With a HELOC, you are still taking out another debt against the available equity of the home, but the similarities with home equity loans end there.
A home equity line of credit provides a flexible credit line – instead of a fixed loan – from which you can borrow multiple times in almost any amount. Think of a HELOC as a significant credit card account, tied to the equity in your home. Like a home equity loan, repayment is necessary, but you may be able to pay only interest for a select period of time.
Costs and Repayment Terms
Home equity lines of credit and home equity loans differ not only in how the money is accessed but also in costs associated with establishing and maintaining an account.
Lender Fees
Most lenders offering home equity loans charge fees for items like a credit report check, a property appraisal, legal fees, and underwriting expenses. These closing costs can range from two to five percent, but in some cases, you can roll them into the home equity loan instead of paying for them upfront.
Home equity lines of credit typically have much lower closing costs, if any at all. There may, however, be an origination fee that you pay once to cover the expenses the lender incurs when establishing an account. Homeowners may also pay an annual maintenance fee to keep the line of credit open or a fee for drawing on the home equity line of credit over time.
Interest Rates
In addition to the upfront costs of home equity loans and lines of credit, you also need to pay close attention to the inherent expenses that come by way of interest rates. One of the appealing aspects of a home equity loan or line of credit is the ability creditworthy homeowners have to secure a lower annual percentage rate (APR) than they might be afforded with a personal loan or credit card.
Home equity loans typically have lower interest rates that are fixed for the life of the loan; home equity lines of credit have variable rates that fluctuate over time and may be higher than home equity loan rates.
Repayment Terms
Also, repayment terms vary between home equity loans and home equity lines of credit. For most home equity loans, repayment is a fixed amount of principal and interest that begins immediately and extends up to 20 years.
Home equity lines of credit have more flexible repayment terms, based on the amount drawn from the account. Some lenders offer interest-only payments for a period of ten years, then principal and interest for the next ten or 15. Others may require principal and interest over a set timeframe.
Best Uses for Homeowners
In answering the question, is a home equity loan or a home equity line of credit better, you need to look at your need for the money first.
Home Equity Loan
Home equity loans are best suited for homeowners who have a known financial need, such as a renovation or debt consolidation. Receiving a lump sum of cash to pay for these expenses can be beneficial if it is cost-effective from an interest rate and closing cost perspective. However, if you don’t need to use the full loan proceeds right away, you will get charged interest on the entire amount.
HELOC
A home equity line of credit is often recommended for homeowners who have ongoing financial needs that are smaller or less predictable. The flexibility of a home equity line of credit can prove advantageous because it limits homeowners from taking out a large lump sum when they may not need it.
This means of borrowing can also be more cost-effective for those who want to pay interest-only for a period of time and get charged interest only on the funds they use. However, a HELOC may be more expensive in the long run because of a variable interest rate, and it’s easy to use at will for other things.
Final Thoughts on HELOC vs Home Equity Loan
Homeowners who have accumulated equity in their home can benefit from either a home equity loan or a home equity line of credit, based on their needs. It is important to note that both types of borrowing require an application that is similar to a traditional mortgage loan application.
Lenders want to ensure you are not borrowing more than 80 to 90 percent of your total home equity, and that you have the means to repay the amount given to you. This means having strong credit, and steady income is necessary to qualify with most lenders. When that is in place, consider if you prefer the flexibility of a HELOC for ongoing needs or if a lump sum is a better fit for you.
