Understanding Equity Loans & Lines of Credit
One of the many benefits of owning a home is the ability to access the equity for things such as home improvements, debt consolidation or financing high-ticket items like college tuition.
There are two main ways to access your home’s equity. The first is a home equity loan, also referred to as a second mortgage or a term loan. The second option is a home equity line of credit or HELOC. Whichever option you choose, the bottom line is, homeowners are using their house as collateral to obtain this financing.
What’s The Difference Between an Equity Loan and a HELOC?
An equity loan is a predetermined, secured amount of money. There can be closing costs associated with a second mortgage, which can be added to the loan amount. With an equity loan, you receive the full amount of the loan up front. So, if you get an equity loan for $150,000, you will receive a check for that sum.
A HELOC is secured debt in a pre-set amount but functions more like a credit card where you write a check for what you need when you need it.
Both HELOCS and equity loans add to the combined loan-to-value ratio on your house. This ratio compares what the homeowner owes versus the market value of the property and is a factor lenders look at when underwriting future loans.
Equity Loan Features
Once approved for an equity loan, you will get the full sum at once and start making payments immediately. You will most likely have a fixed interest rate and be able to write off the interest on your tax return, just like with your first mortgage. Generally, equity loans are best for large home remodels where a significant amount of money is needed.
HELOCs are perfect for obtaining smaller monetary increments then equity loans. Though you have the funds at your disposal, you only owe interest and monthly payments on what you spend. If you have a $50,000 line of credit and spend $10,000, you will accrue interest and monthly payments will be due on that amount only. Lines of credit often have adjustable interest rates and like equity loans, the interest is tax deductible. Also, be aware that your lender may freeze your available funds should they feel the value of your home has dropped significantly.
Paying Your HELOC
HELOCS also have what is called a ‘draw’ period, normally 10 years during which monthly payments are interest-only. Once the draw period ends, you enter into the amortization period where you pay both principal and interest, often doubling the amount due each month. Many homeowners refinance their line of credit prior to the amortization period to keep their monthly payments at a minimum. This can be done by obtaining a new HELOC and paying off the original, paying off your credit line with an equity loan or refinancing both the HELOC and first mortgage into a new, primary home loan.
Paying Your Equity Loan
In most cases, equity loans must be paid in full within 15 years, though the exact terms can vary from lender to lender. Term loan interest rates are normally fixed and are significantly less than obtaining a personal loan or that of the typical credit card. Like your primary mortgage, you will pay a fixed monthly payment that includes both principle and interest.
Utilizing the equity in your home can help pay for home improvements, college tuition, bill consolidation as well as a variety of other things. To determine whether an equity loan or a home equity line of credit is in your best financial interest, it is definitely worth having a chat with your financial consultant and/or your CPA. It also pays to shop lenders for the best rates and options to fit your situation.