Borrowing against the equity in your primary residence is a common way to achieve certain financial goals. Home equity often represents one of the most significant sources of borrowing power throughout a lifetime, especially if you live in a high-growth area or have lived in your home for an extended period of time. You can utilize your home as a cost-effective way to finance major expenses, including home renovations, family vacations, college funding for children, or the consolidation of high-interest debt.
However, borrowing against that equity can be complicated due to the sheer number of options available through private lenders and financial institutions. Here we take a look at the different types of home equity tools and considerations for each.
Home Equity Loan vs. Line of Credit
First, it is important to understand the difference between the two types of borrowing available when you have equity in your home: the home equity loan and the home equity line of credit. Both allow you to borrow, up to certain limits, the difference between your first mortgage and the appraised value of your residence. However, a home equity line of credit is a revolving account, while a home equity loan is fixed.
With a home equity line of credit, you are allowed to borrow up to your credit limit, similar to a credit card. You can take withdrawals from the line of credit up to the amount you need at any time during the line’s draw period.
With a home equity loan, you borrow a fixed amount, similar to a personal loan. If you determine you need additional funding, you would be required to submit a new application or work with your lender to increase your total loan amount.
Repayment for either a home equity loan or line of credit can be extended for up to 20 years, and interest rates applied to both lending options are more attractive than credit cards or personal loans.
Fixed or Variable?
With home equity loans, you have the option to select either a fixed interest rate or a variable interest rate. Each interest option has its advantages and drawbacks which you should take into consideration prior to accepting your new loan. A fixed interest rate is just that – fixed for the life of your loan. This makes repayment calculations simple and allows you as the borrower to understand the extent to which your budget can accommodate your new loan. In some cases, a fixed interest rate on a home equity loan may be slightly higher than a variable rate, but over time, it often ends up being less expensive because it does not fluctuate.
A variable interest rate on a home equity loan fluctuates over time, in line with the broader interest rate market. During a low-interest-rate environment, variable home equity loans are attractive because, initially, they seem to have a lower overall cost. However, as interest rates rise, your variable rate has the potential to follow suit. When this takes place, the total cost of your loan increases, as do your monthly payments, although these increases are capped.
If your cash flow can handle an increase in your repayment terms, a variable interest rate may be your best bet. If not, you’ll want to select a fixed rate.
Factors to Consider
With a home equity loan, there are certain factors you want to take into account prior to borrowing. These include:
- Your interest rate: whether it is fixed or variable, and how that impacts your ability to repay the loan over time
- Fees with your lender: financial institutions and private lenders differ greatly when it comes to costs associated with funding a new home equity loan. It is necessary to shop around prior to securing your new loan to ensure you are not paying exorbitant or unnecessary fees when your loan is funded.
- Equity: to qualify for a home equity loan, you must first have equity to borrow against. If you recently purchased your home or the property has experienced a decline in market value, going through the process of applying for a home equity loan may be a pointless exercise.
- Credit: all lenders require that each borrower listed on a home equity loan application has a strong history of repayment with other creditors. Your credit score, other debt obligations, and income will most likely be evaluated prior to a lender granting you a home equity loan.
Home equity borrowing can be an invaluable tool in your financial planning aspirations, but there are a number of aspects of a home equity loan that must be understood first. Know whether a fixed loan repayment is in your best interest, and recognize the difference between fixed and variable interest rates. Take the time to shop around prior to accepting any new funding from a lender, and remember the appraised value of your home and your credit history play a factor in approval.
