Home Equity Loan vs. HELOC: Pros and Cons, How to Choose
Updated: Sep 19, 2020
In simplified terms, a home equity loan is a type of mortgage that lets you access the equity (the available financial value) of your home.. With this type of loan you take out the total amount that you intend on borrowing all at once, and make payments towards paying it back every month. The time frame can range anywhere from five to fifteen years.
A good formula when figuring out what you will be allowed to borrow, is anything you are allowed to borrow against your home’s current value minus any outstanding mortgages on your property. Most lenders will lend up to 80% of the available equity in your home.
How home equity loans work, is they can provide homeowners access to large amounts of money. They are also sometimes preferred to other loan types because they are typically easier to qualify for, since you are using your own home as collateral.
The amount you are allowed to borrow will depend on your current equity as well as your home’s market value. If approved, the loan will have a set term and interest rate, very similar to your current mortgage.
For example, if your home is currently valued at $300,000 and you have a mortgage balance of $225,000, that leaves a potential $75,000 that you could borrow against. Keep in mind that there are some potential risks, which we will outline a little bit further down. (Note: Generally, most lenders will lend up to 80% of the equity, in this case, $75,000 x 80% = $60,000)
Is A Home Equity Loan A Good Idea?
When it comes to home equity loans, there are many benefits. They typically have lower interest rates than most other credit cards and personal loans and there is a faster close time compared to any other cash-out refinance options. Home equity loans are usually easier when budgeting, because the fixed rates allow you to schedule predictable payments.
Some people worry about the risk it could possibly bring to their mortgage, but if your current mortgage rate is low, you won’t even have to give that up to take out a home equity loan as the new loan will simply be seen as a second mortgage or a second lien on your property. It’s even possible to claim a tax deduction for any interest you pay, but only if you are using the loan to build, buy or improve your current home.
On the other hand, home equity loans offer less flexibility in comparison to a home equity line of credit. You also might have a slightly more difficult time finding lenders that prefer offering lump sum loans (like a home equity loan) instead of offering a home equity line of credit. It’s also worth mentioning that you may end up paying more over time.
With a home equity loan you will be paying interest on the loan amount entirely, even if you are not using it all at once. So for instances such as an ongoing remodeling project where you will use the money in increments, you will still be paying the interest as if you used the entire loan amount.
Can You Use A Home Equity Loan For Anything?
Technically, you can use your home equity loan to pay for anything, because they assist you in financing things you may not be able to buy with your current monthly salary. Some of the more common uses for a home equity loan include:
Medical expenses: Whether you have just been faced with large amounts of medical debt, or you have tried other avenues like a medical loan, a home equity loan might be the next option to try. Especially if there has been a major surgery or even a rehabilitation bill, high medical bills add up, and they add up quickly.
Education: Loans are being taken out for furthering education every day, and a home equity loan might be an avenue for some people. They can assist in paying for college or even to pay a private secondary school’s tuition.
Remodeling - One of the more popular reasons for taking out a home equity loan, is to add to the current value of your home. Contractor fees and materials add up when trying to add value to your home, which is why many people rely on these kinds of loans to cover those costs, hopefully to recoup that amount later on when the house is sold again for a higher amount.
However, it might be smart to also realize that there are some cases where a home equity loan might not be the smartest financial solution.
Starting your own business - When starting your own business, there is risk around every corner. Which is why it’s not highly recommended to use your home equity loan to cover those start up expenses. There is potential for you to pour all of your home equity into a business that might fail, leaving you unable to make payments. Worst case scenario when getting behind on loan repayments, is since you used your house as collateral, you might end up losing your home, as well as your new business.
A large sum of money is not needed - If you don't plan on using the large lump sum of money all at once, then this might not be the kind of loan for you. In fact, a home equity line of credit might be better situated for you, since you are only required to pay for the portion of the loan you used. We will get into that type of loan shortly.
Can You Refinance A Home Equity Loan?
Over the time you first took your home equity loan out to now, it might be good to consider refinancing. If you have an existing home equity loan and perhaps want to fund a new project, refinancing might make the most sense. For most circumstances, doing so can result in lower interest rates, ability to change payment terms, and create more flexibility for yourself.
Besides being able to borrow additional funds for a new project or need, refinancing at a later date may also result in locking in lower interest rates then when you originally took out the loan. It might also be an option to switch from an adjustable rate to a fixed rate that allows for more flexibility, or vice versa.
Once you have decided that you can benefit from refinancing, make sure you cover some preliminary steps to ensure you are getting the most from your home equity loan. Make sure you establish your borrowing needs and have a realistic payment goal in mind. This will allow you to come prepared when trying to refinance your home equity loan.
You should also take the time to calculate the new amount of equity you are now able to borrow against. Things may look different from when you originally took out your home equity loan, so make sure your credit score is still in good standing and you have all the documentation lenders will be looking for.
What Is A Home Equity Line of Credit (HELOC) and How Does It Work?
A home equity line of credit, or HELOC, offers homeowners the capability to access any equity in their home through use of revolving debt. With this line of credit option, you only end up paying for what you use. As the balance decreases, the money becomes available again to you. This option gives you the freedom to borrow up to a particular amount over a ten year span of time.
Usually, this option is more flexible in comparison to a home equity loan because you will always have control over your loan balance and the interest costs. Since you will only be paying interest on the amount of money you actually use, this option is best when people are not entirely sure what they will financially need in the upcoming future.
Pros Of Getting A HELOC
Just like with a home equity loan, a home equity line of credit has its advantages. For example, most lenders will allow those that are worried about the varying interest rates to take out a portion of what you owe on your home equity line of credit and convert it into a fixed rate.
If you are not completely positive on what you will be spending your loan on, and the exact amount, a home equity line of credit lets you pay interest compounded only on the amount of money that you use, and not the entire available equity.
Cons Of Getting A HELOC
Although having control of the amount of money you take out with your loan seems like a great thing, it might be a dangerous line to walk if you are not on top of your finances.
If you don't have discipline, it might be easy to overspend when it’s not necessary. This will tap out the equity in your home, and you will now be faced with larger principal and interest payments when it becomes time to repay.
Pay close attention to the interest rates during the time you have your loan out, because since you do not have a locked in interest rate, they can change and you will end up having to increase your payments.
Just like with interest rates, fluctuating monthly payments each month can cause some financial instability, so stay alert and aware of what is happening while you have your loan out.
Home Equity Loan vs. HELOC: At A Glance
The easiest way to decipher the two is by realizing that a home equity loan is good for those who need a specific amount, know about how much it is, and know exactly where the money is going.
A HELOC, on the other hand, might be better for those that either aren’t sure exactly how much they need or for those who simply want the peace of mind of knowing the money is available should they need to use it.
While a home equity loan and a home equity line of credit are seemingly similar, there are a few aspects that set them apart. They can also differ from one lender to another, so it is important to completely understand the repayment terms of your loan before committing to anything.
If you’re interested in getting a home equity loan or a HELOC, you can go to check with your local banks or read through the following article: Best Home Equity Loans.
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