A Guide for Home Equity Loans and HELOCsFebruary 21, 2022 by X2 Mortgage
Home Equity Loans (HEL) and Home Equity Lines of Credit (HELOC) are two types of loans that allow homeowners to borrow against their homes' value. They are also called second mortgages because the homeowner's primary mortgage is untouched meaning the homeowner will have two mortgages secured by their home. They offer flexibility and convenience, allowing homeowners to access cash without selling their home or refinancing out of their first mortgage.
Homeowners who want to refinance to consolidate debt or do some revonations around the house often consider using a home equity loan or line of credit. These options offer several advantages over refinancing through a conventional mortgage.
In this guide, we will explore the home equity loan process, how they work, and how to get your home equity loan approved.
What is Home Equity?
To understand what Home Equity Loans and HELOCs are, first, you must understand what equity is. Simply put, home equity is the difference between the amount you owe on your mortgage and the current value of your home.
The more equity you have in your home, the more you can borrow. Some lenders allow up to 90 - 95 percent of that equity to be borrowed against. For instance, if your home is currently worth $380,000 and your current mortgage loan balance is $150,000, you have $230,000 in tappable equity. In other words, if you've paid down your mortgage loan to the point where the home's value exceeds the outstanding loan balance, you can borrow a percentage of the difference or equity.
If you’re looking to borrow money against your home, then a home equity loan may be right for you. A home equity loan allows you to tap into the equity built over time in your house by taking out a new loan against it. This means you can take out a larger amount than what you originally borrowed, which could help pay off other debts or finance large purchases like a car.
However, there are some disadvantages to this type of loan. For example, interest rates will typically be higher than those offered with a standard mortgage, and you may not qualify for one if you already owe too much on your home.
How Does a Home Equity Loan Work?
A home equity loan is like a traditional mortgage loan in that a qualified homeowner gets a loan for a set amount of money that is secured by their home. This loan can be used to finance any project, purchase, or investment.
The loan is typically repaid with equal monthly payments over a set period, usually between 5 and 30 years. Each payment reduces the loan balance and covers interest costs based on an amortization schedule.
How Much Can I Borrow?
Although many lenders prefer that you borrow no more than 80% of the equity in your home, the maximum amount you can borrow depends on several factors, including:
The size of your property
The current market value of your home
How long do you plan to keep the loan
Your income levels
Whether you want to repay the loan using a fixed rate or an adjustable-rate
Any existing debt you have
If you own another property
What kind of specific loan you apply for
You can get a rough idea of how much you might be able to borrow by talking to a mortgage expert. They can help calculate your potential borrowing power based on your situation and show you the best possible deals.
Calculating Your Home’s Value
To calculate how much equity you might have in your home, you should subtract the total mortgage balance from the current market value of your home. You can find the current market value using a real estate agent or a mortgage broker.
If you plan to refinance your existing mortgage, you can get an estimate of the new mortgage payment by contacting your lender. If you plan to purchase a new home, you can contact a local real estate agent to see what houses similar to yours sold for recently.
When it's time to start processing your Home Equity Loan, your lender will either order an appraisal to determine the fair market value or order what's called an AVM report (Automated Valuation Model) which auto calculates value based on data readily available.
Pros of Home Equity Loans
The fixed loan amount paid in a lump sum can handle large expense projects at once.
It offers lower interest rates than other finance options.
Fixed monthly payment amount makes it easier to budget.
Interest may be tax-deductible in certain circumstances.
You can use it to fund anything you wish, including small and large expenses.
Cons of Home Equity Loans
Most have high home equity (15 to 20 percent) requirements.
When you can't pay back your loan, you risk losing your home.
If your home's value drops, you might end up paying more than it's worth.
You cannot borrow more money for an emergency unless you take out another loan.
To get a lower interest rate, you must refinance.
What is a HELOC?
A home equity line of credit (HELOC) is a recurring credit line secured by your home. It allows you to borrow money against your home equity, pay it back, and then borrow money again.
How Does a HELOC Work?
HELOC works in the same way as a credit card. Instead of a lump sum like a home equity loan, you get a credit line based on the value of your home with this loan option.
For example, if a lender approves a credit limit of $50,000, you are allowed to withdraw money from the account as often as you need over a period known as the draw period. That is, you wouldn't have to borrow the entire $50,000 in one go. Instead, during the draw period, you can take out $15,000 now, $3,000 later, $6,000 at a later date, etc... up to the credit limit. You can use a credit card or a check to access your credit line.
The draw period is the first phase of a HELOC, which typically lasts 5 to 10 years, during which you are only required to pay interest on the money you take out. However, you can still make payments towards the principal during the draw period even if you’re not required to.
Following the draw period comes the second phase, the repayment period, which typically lasts 10 to 20 years when you are required to repay the loan principal.
How Much Can I Borrow?
How much money you can borrow on HELOC depends on your credit score and history, employment history, monthly income, and monthly debts. Lenders typically allow you to borrow up to 85% - 90% of the value of your home, minus the amount owed on your first mortgage.
The interest rates on most HELOCs are adjustable. This means that your interest rate may rise or fall over the course of the loan. HELOC interest rates are calculated by adding a margin to the prime rate, which fluctuates based on market conditions. The lender determines the margin and it's typically based on your creditworthiness. Fixed-rate HELOCs are available from some lenders, but they're less common.
How to Find the Best HELOC Rates
The borrower's credit scores heavily influence the interest rate on a HELOC. To get the best rates, you'll need a high credit score, a low debt-to-income ratio, and a lot of tappable equity in your home. Plus, you'll want to work with a mortgage broker who can shop your scenario out to all available lenders for the best deal.
Pros of Home Equity Line of Credit
There are a few restrictions on how you can spend the money.
It allows for interest-only payments during the draw period.
It has a much lower interest rate than other types of credit lines.
Interest may be tax-deductible
The money doesn't need to be withdrawn right away, giving you a safety blanket of cash in case of an emergency.
Cons of Home Equity Line of Credit
Because interest rates are adjustable, they may rise in the future.
Without discipline, you may overspend, depleting your home's equity and pay with large principal and interest during the repayment period.
When you cannot repay your loan, you risk losing your home.
Monthly payment fluctuates due to fluctuating interst rates (in most cases).
HELOC vs Home Equity Loan; Similarities and Differences
Both are second mortgages that can be used in addition to an existing home-purchase loan.
Both home equity loans and HELOCs allow consumers to access funds that they can use for various purposes, including debt consolidation and home improvements.
Your home's equity secures both. There must be sufficient equity in the home, which means you must pay down your first mortgage sufficiently to qualify for a home equity loan and HELOC.
Interest on home equity loans and HELOCs are tax-deductible as provided in the Tax Cuts and Jobs Act enacted in 2017. To be eligible for the equity loan tax deduction, the loan must be secured by your primary or secondary residence; the funds must be used to improve the home; the total debt associated with the house cannot exceed $750,000.
The lender typically limits the amount you can borrow with both home equity loans and HELOCs to a certain percent of the value of your home. Although some lenders allow you to borrow more, as you borrow more, your interest rates and costs rise as you borrow more. For the best loan terms, keep your loan-to-value (LTV) ratio below 80%.
While a home equity loan is an installment loan with your home as collateral, a home equity line of credit (HELOC) is a revolving line of credit; think of it as a low-interest credit card secured by the value of your home.
HELOCs usually have a 10-year "draw period" during which you can borrow several times. You can generally access the funds by writing checks, using a payment card linked to your loan, or transferring funds to your checking account. However, you get everything all at once with a home equity loan. As a result, a home equity loan can provide a large sum of cash for large expenses.
The interest rate on a home equity loan is fixed, which means it does not change over time. A HELOC has a variable interest rate, which can rise or fall over time. HELOC interest rates are typically much lower than credit card interest rates, making them an option for people who have a lot of credit card debt and want to save money on interest payments.
How to Get an Equity Loan: Requirement and Eligibility
Most lenders have similar eligibility requirements for HELOCs and equity loans. In most cases, Lenders typically use credit score and history, income, home value, and other factors to assess the risk of lending a certain amount of money against the equity in a property. Let us consider some of the fundamental requirements.
Credit Score and History: To qualify for an equity loan or credit line, you must have a credit score of 600 or higher. You must also have a track record of paying bills on time.
Income: Lenders are also interested in your income to determine how you will repay the loan. As a result, you need a stable income and good employment history to qualify for the loan. You will be required to provide pay stubs, W2s, and/or tax returns as proof of your income.
Amount on Equity: Because your home secures your loan, most lenders require an appraisal of your home or AVM to qualify for a HELOC or home equity loan. The equity in your home must meet lender's requirements.
Debt-to-Income Ratio: To be considered for home equity borrowing, lenders calculate your debt-to-income ratio to determine whether you can afford to borrow more than your current obligations. To calculate your estimated DTI ratio, add your monthly debt payments and other financial obligations, such as mortgage, loans, and credit cards, divide the total by your monthly income and convert the result to a percentage. If you earn $7,000 per month and make payments totaling $2,500, your DTI is 36%. To qualify for a home equity loan, you need a DTI ratio of 43% - 60% or lower (depending on other factors).
Lenders may vary on specific borrowing processes and requirements, depending on their level of risk tolerance, default probability, and underwriting formula. It is essential to compare rates from multiple lenders when applying for a HELOC or home equity loan.
If you cannot afford your estimated monthly payment, you may want to explore refinancing options. Refinancing allows you to change the terms of your mortgage. For example, you can lower your rate, extend the term of your loan, or even combine several mortgages into one large loan with a single monthly payment.
Home Equity Loan v. Refinancing
Home equity loans, HELOCs, and refinances are all funding options that allow you to convert some of your home equity into cash.
Refinance (or cash-out refinance) is a loan option in which you apply for a new mortgage larger than your current loan balance. The new loan pays off your old mortgage and any closing costs, and you receive the difference in cash. In addition, you'll receive a new monthly mortgage payment based on your new loan terms and balance.
Refinancing can be a great way to obtain new mortgage rates and terms, lower your monthly payments, and get a lump sum of cash. But if you need cash for home improvements, purchases, or investments, and you are comfortable with your current mortgage rate, home equity loans may be a less expensive option for you.
Home Equity Loan or HELOC, Which is Better?
Before deciding whether to apply for a HELOC or a home equity loan, you should ask yourself... What is the purpose of the loan? Consider how much money you truly require and how you intend to spend it. Other factors to consider when weighing your options include interest rates, fees, monthly payments, and tax advantages.
A home equity loan is a good option if you know exactly how much money you need to borrow and how you intend to spend it. When approved, you are guaranteed a certain amount, which is paid in full when the loan is advanced. As a result, home equity loans can assist with large expenses such as paying for a child's tuition, renovating, or consolidating debt. On the other hand, HELOCs are typically best suited for people who require funds for ongoing home improvement projects or who need more time to pay off existing debt.
HELOCs may be a better option for people who need a revolving credit line for unforeseen expenses and emergencies. A real estate investor, for example, would find a HELOC to be a more convenient and streamlined option than a home equity loan for purchasing and repairing the property, then paying down their line after the property is sold or rented and repeating the process for each property.
In a Nutshell
Home equity loans and HELOCs are low-cost loan options that allow you to access the equity in your home. You can take out a second mortgage for various reasons, including financing other investments and paying off other debts. Regardless of which option you choose, try to spend the money on things that will yield value rather than frivolous purchases or vacations.