If you need a quick cash injection and own sizeable equity in your home, equity loans can help.Â Home equity loansÂ andÂ home equity lines of creditÂ areÂ low-interest rateÂ loans taken out against your home. Also known asÂ second mortgages, they allow homeowners to tap into their equity, and offer a plethora of benefits, as well as a few downsides.
But which option is best for you and your needs, how do they differ, and what can they be used for?
Home Equity LoanÂ vsÂ Home Equity Line of Credit
Home equity loansÂ and lines of credit are types ofÂ second mortgages, which means they often exist in addition to your primary mortgage. They are secured against the equity that you own, and the size of that equity will dictate how much you’re offered and what sort of rate you’re provided with.
AÂ home equity loanÂ gives you aÂ lump-sumÂ payment in exchange for securing your equity. A home equity line of equity, also known simply as aÂ HELOC, is a line of credit that works a lot like aÂ credit card.
In both cases, you are not selling your home or any part of it. You’ll still technically own all the equity that you secure against the loan, but if you ever default on it then the lender may seek to initiate foreclosure.
Of course, because they areÂ second mortgages, the primary lender will take priority in the event of a complete mortgage default, but once they have secured their share then theÂ second mortgageÂ lender will take theirs.
Home Equity LoanÂ Details
- Payment Type:Â Cash paidÂ upfrontÂ
- Interest Rate:Â Fixed-rateÂ of interestÂ
- Interest Charges:Â Pay interest on the entire balance
- Closing CostsÂ and Fees:Â Closing costsÂ and fees charged
- Repayment:Â FixedÂ monthly paymentsÂ that never change
Home Equity Line of CreditÂ Details (HELOC)
- Payment Type:Â Money paid as a line of credit during aÂ draw period
- Interest Rate:Â VariableÂ interest rate.
- Interest Charges:Â Only pay on what you withdraw from theÂ credit line
- Closing CostsÂ and Fees:Â Closing costsÂ and fees tend to be lower
- Repayment:Â Interest-only payments possible
When to Consider aÂ Home Equity Loan
Towards the end of this article, we’ll discuss some of the ways you can use aÂ home equity loanÂ orÂ HELOC, covering both the positive and the negative. But for now, it’s important to understand which of these options is best for you based on your current situation.
AÂ home equity loanÂ may be the better option if:
You Need A Lot of Money Now
The main reason to opt for aÂ home equity loanÂ is if you need a lot of money and you need it sooner rather than later. This is generally the better option is you have a specific amount in mind, such as if you have a vacation planned or medical bills to pay and have been given a specific quote.
That way, you know how much to borrow and can use the money straightaway, before focusing on making repayments.
It gives you some clarity and certainty, as you’ll be told how big yourÂ monthly paymentsÂ will be, how long they will last, and how much money you’ll get in return for yourÂ home’s equity.
It’s important to take a little as possible, but to make sure you have more than you need. That seems like a contradictory statement, but for example, if you are planning a cruise around the Mediterranean and have been quoted $15,000 for you and your family, you should consider taking $20,000 instead.Â
That way, you’ll be covered for spending money and unforeseen expenses and wonât need to resort to taking outÂ personal loans, cashing savings or putting everything on yourÂ credit cardÂ when you realize you’re short.
You Want aÂ FixedÂ Interest Rate
AÂ home equity loanÂ will typically cost you much less than aÂ HELOCÂ over theÂ life of the loan. It also charges a fixed monthly amount, one that doesn’t change regardless of theÂ prime rateÂ and your accumulated equity.
Understanding how much you will be expected to pay over theÂ loan termÂ can help you to prepare and keep nasty surprises at bay.
You Have Debt to Repay
One of the best uses of aÂ home equity loanÂ is debt consolidation, whereby you use the loan to pay off your current debt. If you have a lot of debt tied up inÂ credit cardÂ balances andÂ personal loans, chances are you’re paying a much higher rate of interest than with aÂ home equity loan.
Therefore, by swapping one big secured, low-interest debt for lots of small, unsecured, high-interest debts, you could pay much less interest over theÂ loan term.Â
Calculate how much debt you have; how much it is costing you every month (and over the term) and make sure you considerÂ prepayment penaltiesÂ as well. You can then calculate the same projected costs for aÂ home equity loanÂ and will likely discover that the latter will save you thousands when used to clear your debt.
Of course, for this to work, theÂ home equity loanÂ needs to provide you with a sufficientÂ amount of moneyÂ to cover all of your existing debts, which is reliant on yourÂ home’s valueÂ and yourÂ loan-to-valueÂ ratio.
When to Consider aÂ HELOC
On the surface, aÂ HELOCÂ can seem like a better option. TheÂ loan amountÂ isn’t as high and the money is released over aÂ period of time, as opposed to a singleÂ lump-sum. But that could provide some huge benefits for certain types of homeowners.
You Don’t Know How Much You Will Need
If you have a couple of big events coming up, such as a wedding and honeymoon, and you don’t know how much money will be needed, aÂ HELOCÂ may be the better option. With aÂ HELOC, you can draw money as you need it, paying interest only on the amount that you draw.
You will typically be charged a higherÂ interest rateÂ for thisÂ type of loan, but it means you can use the money to make staggered payments, such as a debt clearance this month, a wedding in a few months, and a vacation at the end of the year.
Your Income Rises and Falls
If you’re self-employed and don’t have a consistent or reliable income, aÂ HELOCÂ may be better than aÂ home equity loan. With aÂ lump-sumÂ loan, the money typically goes quickly and then, if you encounter a slow period at work or you’re hit with a major bill, you don’t have many options for repayment.
But if you have aÂ HELOC, you also have a line of credit waiting for you, one that can get you out of trouble when you need it.
âPros and Cons of aÂ Home Equity Loan
- ProÂ = Large cashÂ lump-sumÂ (based onÂ home value) to spend as you please.
- ProÂ = AÂ fixedÂ interest rateÂ is charged.
- ProÂ = TheÂ repayment periodÂ and theÂ monthly paymentÂ is fixed and remain the same.
- ConsÂ =Â Interest paymentsÂ may be higher than yourÂ firstÂ mortgage.
- Cons = Your home equityÂ is at risk.
âPros and Cons of aÂ Home Equity Line of Credit
- ProÂ = Interest is only charged on the amount you withdraw.
- ProÂ = Borrow money as and when you need it during theÂ draw period.
- ProÂ = Can be used to make multiple small payments.
- Pro = LargeÂ credit limit, depending on theÂ value of your homeÂ and the size of your equity.
- ConsÂ = Only offered by credit unions and traditional banks.
- Cons = Your home equityÂ is at risk.
- ConsÂ =Â Interest rateÂ is variable, and the loan is open ended, making it difficult to judge how much you will pay over theÂ life of the loan.
How to Use Home EquityÂ Home LoansÂ
There are many reasons you may want to consider aÂ home equity loanÂ or aÂ HELOC, some more preferable to others, but all viable and all allowed. In fact, as long as you have the equity and meet your payments on time, the lender won’t care how you spend the money.
College tuitionÂ is expensive and student loans don’t always cover everything that you need, especially if you’re studying for an advanced degree or you’re a mature student.
You need to think about living expenses as well asÂ college tuitionÂ fees and equipment, and aÂ HELOCÂ orÂ revolving line of creditÂ can provide you with more options, more variety, and potentially aÂ lower rate.
Major expenses like funerals and medical bills can arise unexpectedly and hit you hard, taking savings or leaving you with few options. If you have a significant share in your own home, however, then aÂ home equity loanÂ could help.
These loans can give you a cash sum to be used on everything from weddings to funerals and medical bills, helping you to dig yourself out of trouble.
Spending yourÂ home equity loansÂ or credit on a vacation is risky, as you’re using a secured expense tied to your most important asset to purchase something that is fleeting and won’t give you any tangible assets.Â
However, we all need to live a little and while vacations can’t pay you interest or dividends and won’t appreciate in time, they will give you memories that last for a lifetime and allow you to place one extra tick on your bucket list.
One of the most common uses for equity loans is toÂ remodel, renovate or complete a majorÂ home improvementÂ project. The costs of this project may beÂ tax-deductibleÂ and could help to significantly boost theÂ marketÂ valueÂ of your home.
As discussed already, this is probably the best way that you can use aÂ home equity loanÂ as it’s one of the few options (along withÂ home renovation) that may actually result in you saving/gaining money over the long term due to theÂ lowerÂ interest rateÂ offered by these loans when compared to unsecured debts.
Home equity loansÂ are ideal if you have some equity in your home and need some fast and easy cash. However, simply having a house isn’t enough to get theseÂ types of loans.
Your debt-to-income ratio andÂ credit scoreÂ will both be considered to make sure you can afford to meet theÂ repayment schedule. And even if you do qualify, they may not be the best options available to you.
You can also look into aÂ cash-outÂ refinance, which gives you a larger mortgage than you need and lets you collect the remaining cash, or a reverse mortgage, which is only available to older homeowners who control a large equity stake.
In any case, the more of your house that you own, the moreÂ loanÂ optionsÂ you have and the better the rates and fees will become. So, if you get rejected, keep building that equity and try again in a few years.
Home Equity Loan vs Line of Credit is a post from Pocket Your Dollars.