The Complete Guide to Home Equity Loans and HELOCs
Want to use your home to get money for a major purchase or investment? You can use two offers — a home equity loan or HELOC. Both options provide access to money, but some features and risks cannot be ignored.
The Basics of Home Equity Loans
If you own a house, you can use your house to get a loan. This works because a bank or lending institution lends you money but holds your house as collateral. The amount one can get is determined by the amount still owed on the house and the current value of your home. With less debt, you will be able to get approved for more money.
Their interest rate is fixed, so payments are equal throughout the repayment period. The repayment periods range from several years up to several decades. You get the entire loan amount once and repay it monthly. If, for some reason, you can't pay off the debt, then the lender may begin procedures for getting money back by selling your home.
Before taking out this type of loan, you need to weigh its pros and cons:
Pros
- Easy to budget as monthly payments are the same throughout the term (fixed interest rate)
- You receive the entire loan amount at once and can use it for any needs.
- In some cases, there is no additional fee for processing the loan, which reduces processing costs.
- If you use the money to improve your home, then the interest on the loan can be deducted from your taxes.
Cons
- You must determine exactly how much you need to borrow. If you take more or less, you must either pay the extra amount or borrow more.
- To get a loan, you must have equity equal to at least 15-20% of the house's value.
- If you do not pay on time, you can lose your house.
- If the value of your home suddenly decreases, you may find yourself owing more than the value of your property.
What You Need to Know About HELOCs?
This loan also requires collateral in the form of a house. However, unlike a standard loan, you can access a certain amount but only use the portion you need. The amount you can be approved for depends on the market value of your home. Interest will only be charged on the amount you borrow.
The interest rate on a home equity line of credit can change over time depending on market conditions. The initial rate depends on your credit score and the amount you request.
A HELOC works in two stages:
- The borrowing period. This is when you can borrow an amount of money up to your limit; you will pay only the interest, and this stage usually lasts for several years.
- The repayment period. At the end of the initial period, a borrower must start paying for the principal and interest. The period is 10-20 years.
Be prepared for the monthly repayments to shoot through the roof once the minimum repayments expire. Let this sink in: if you are unable to pay, your home could get repossessed because your property secures this loan.
A HELOC, like any financial instrument, has pros and cons that are important to consider before applying:
Pros
- You can pay interest only during the first period, making it easier to make monthly payments.
- You pay interest only on the amount you spend. The rest of the credit line does not incur additional costs.
- Some lenders offer the option to lock in a rate on part of the loan to avoid unexpected interest increases in the future.
Cons
- The interest rate on a HELOC is subject to change, meaning your payments may increase if rates increase.
- Some lenders may charge a fee for using the loan, for early repayment, or for switching to a fixed rate.
- You may lose your home if you cannot repay the amount in time.
- If the value of the home falls or if there is some economic downturn, then the lender can reduce your credit line or may demand the whole amount at once.
HELOC or Home Equity Loan: A Simple Comparison
The table shows the main differences between these financial products:
| Home Equity Loan | HELOC |
|---|---|
| Fixed interest rate | Variable interest rate |
| Your payments remain the same throughout the loan's life. | Payments may vary depending on changes in the interest rate. |
| You receive the entire loan amount at once. | You can withdraw money in parts when necessary. |
| Interest is charged on the entire loan amount. | Interest is charged only on the amount you use. |
| Principal payments begin immediately after receiving the loan. | You can defer principal payments for a while. |
Requirements for Home Equity Loans and HELOCs
To get one of these types of loans without any problems, you need to understand the requirements and conditions of lenders:
- Credit score. The minimum credit score should be from 620 to 650. The higher your score, the more favorable terms and interest rates you will be offered. A credit score of 700+ gives you better terms and low interest rates.
- Equity in real estate. Banks usually require that the borrower have at least 15-20% equity in the property.
- Debt load. The maximum debt-to-income ratio (DTI) should not exceed 43-45%. Your total debt obligations, including mortgages and other loans, should not exceed 45% of your income.
- Income and employment. Banks require proof of a stable income for the last 2 years. If you are employed, a certificate from your place of employment is required. If you have a business, you must provide tax returns and other financial documents.
- Property type. The property must be residential (not commercial) to qualify for a secured loan or HELOC. In addition, it must be in good condition. Some banks may refuse if the house is over 30 years old or has significant damage.
- Property insurance. The lender will require a policy covering property loss or damage risks. The insurance must cover the value of your home or its market value.
- Application documents. US passport or other identification, as well as home ownership documents (certificate of title). Income verification: tax returns for the last 2-3 years, bank statements, and a certificate from your employment. The bank may request additional documents, such as bank statements and information about other loans.
- Age and place of residence. The applicant must be over 18 years old and own the property. Some lenders require the borrower to be a U.S. citizen or U.S. resident.
- Property appraisal. An assessment of the property will be carried out, based on which the loan amount will be proposed. This process can take several days. For a HELOC, periodic property appraisals may be necessary, especially if you have used the line of credit for a long time.
- Loan amount. For a secured loan, the loan amount is typically between $50,000 and $1,000,000, depending on the value of your home and your financial situation. For a HELOC, the line of credit can be up to 85% of the home's value, depending on your creditworthiness and income.
Understanding How Much You Can Borrow with Home Equity
The amount you'll be able to borrow is a percentage of the equity you have in the property. Equity is your home's value minus what you still owe on your mortgage. Suppose, for example, your home was worth $300,000, and you owed $150,000 against your mortgage; your equity would be $150,000.
Apart from that, the bank will look at the loan-to-value ratio. It defines how much a bank lends to a certain home value. It may vary, with the average usually up to 80-85 percent of its market value. That means if your house costs $300,000, the bank allows borrowing 80% of such value. Hence, the biggest amount would equal $240,000. When you have a remaining mortgage balance of $150,000, you can borrow around $90,000.
Another factor is how much you already owe on your mortgage: the less you owe, the more you can borrow. For example, if your home is worth $300,000 and you owe $250,000, you can borrow only $50,000 if the bank allows an 80% LTV.
Another factor in this regard is the debt-to-income ratio. It analyzes your income and monthly expenses to pay off debts. Banks generally keep the threshold of this below 43%. With a debt of $1,000 from the loan obligations, if your income is $5,000, then your DTI would be 20%. The lower this number, the more likely you will be approved for a larger amount.
You should also consider your credit score: the higher it is, the more funds you can receive on better terms. For example, if it is 700 or higher, you will get better rates with more funds available.
Home Equity Loan & HELOC: What's Right for Me?
Before taking out a home equity loan, it is important to define your financial goals. Just because this is the first option that has come your way, do not select it without considering how each option will affect your financial situation. Here are some guidelines to help you make the right decision:
Determine Your Loan Goals
If you plan a major purchase with a fixed cost, taking out a loan secured by housing will be more logical. However, a line of credit could be the best solution if your goal is flexible, such as long-term home improvement projects or changing expenses.
Assess Your Ability to Control Payments
You may want a loan with fixed terms if each payment is equal and easily calculable over the entire term. However, a line of credit will give you more leeway if you must vary the amounts and wish to make only periodic payments.
Consider Future Risks
When choosing a loan, one should understand how probable economic changes can influence one's ability to repay it. If one doesn't want surprises and is not ready to take risks in the future, it is better to fix the terms with a loan. However, if one feels confident in one's financial situation and is ready for possible payment changes, a credit line will offer more flexibility.
Do You Need the Ability to Reuse a Loan?
When your goal isn't to cover a one-time large expense but rather to have a reserve in case of unforeseen situations, then, in this case, a line of credit will allow you to reuse funds right after you repay the debt. This may be handy in case your future financial needs are quite unpredictable.
Budget Forecasts
A simple calculation will help you understand how comfortably the monthly payments fit into your budget. A fixed loan is best if you plan fixed expenses several years in advance. If you want more flexibility in payments, for example, with minimal payments at the start, choose a credit line.