What are the main differences between these home equity tools?
As a homeowner, your home can be one of the most important tools to access low-cost funds over time. Once you build enough equity, you can secure a low-cost home equity loan or a home equity line of credit (HELOC). These loans generally have low interest rates, but that’s because they use your home as collateral. So it’s important to understand the pros and cons of each loan.
We’ll go through both types of loans and explain the key differences between them. But first, let’s talk about how home equity works.
Home equity explained
Your home equity is the difference between the amount you owe toward your mortgage loan and the value of your home. If you bought a home for $500,000 and paid a 20% down payment of $100,000, your loan is for $400,000. Over time, you’ll pay off that mortgage and continually build your equity as the amount you owe decreases and the value of your home increases.
For example, once you’ve paid off $50,000 of your mortgage, you’ll owe $350,000. But what if your home is now worth $600,000? If you were to sell it, you would first pay off the remainder of the mortgage then keep the remaining balance of $250,000. That number is your home equity—and is what would be available to you as a home equity loan or HELOC.
How to use home equity for low-cost funds
Taking out a home equity loan is like taking out an additional mortgage. Depending on the amount of equity you have in your home, you can borrow cash from that amount and then pay it back with interest in monthly installments over time, similar to how you pay your first mortgage.
Both types of equity loans allow you to tap into your equity without making any changes to your primary mortgage. This is great if you have a good rate on that mortgage, as it won’t be affected. There are other loan options, like cash-out refinancing, where repayment is folded into a new, refinanced mortgage. But both types of home equity loans have a separate, additional payment to your current mortgage.
Home equity loans explained
A home equity loan is a single lump sum of cash equal to the equity in the home. The borrower can then use this cash toward anything. This is best for a one-time major expense, often related to home improvement. But some homeowners choose to put the payment toward other major expenses like education, a wedding, or a medical emergency.
These loans have a fixed interest rate determined by a borrower’s credit score, the amount of the loan, payment history, and income. So depending on your financial situation, this may or may not be right for you. These loans are generally used for large cash payouts that a borrower intends to pay predictably over time.
- Low fixed-rate interest rate
- One large, lump sum
- Predictable payments over time
- Interest is potentially tax-deductible
- Often comes without fees
- High risk if housing market turns downward and you end up under water on your loan
- Requires a high credit score
- Requires considerable equity—usually over 15% of the original loan.
- Defaulting means you lose your home
A home equity line of credit works like a credit card. A lender gives you access to a pre-set amount of funds that you can borrow from as needed, then pay back with interest over time. However, the interest is variable, which means that your rate will change depending on the market and other economic fluctuations.
Just like with a credit card, the amount you pay back each month depends on how much of the credit line you’ve spent. That way, you only pay for what you use and can leave the rest. This kind of loan is good for borrowers who aren’t sure how much they’ll need and want to pay interest only on what they spend.
- Only pay for what you need
- Usually comes without fees
- Flexible repayment
- Variable interest rate may go up
- A long-term credit line may be risky for people who overspend and have existing debt
- You will lose your home if you default
Using home equity to purchase your next home
If you’re in the market for a new home and have less than 20% to put down, you can use a home equity loan to avoid paying mortgage insurance or to help you qualify for a jumbo loan.
Here’s how: apply for a first mortgage that is 80% of your home’s value and simultaneously apply for a home equity loan of 10%, allowing you to add in as little as 10% out of your current funds to get to 20% total. This is known as an 80-10-10 loan or a piggyback loan.
Alternatively, you can Buy Before You Sell with Flyhomes. We’ll provide you with guaranteed funds so you can make a cash offer on your next home and then we’ll use your home equity to give you the funds to make a down payment. Once you move in, you’ll refinance for an affordable rate and repackage it all into one, long-term mortgage.
Wrapping it up
Their names may sound virtually the same, but these two financial programs are very different from one another.
Both a home equity loan and a HELOC allow you to take a certain amount of equity out of your home and both require monthly payments to pay back the amount that you borrow.
The main difference between the two is that a home equity loan provides you with the cash in one lump sum, whereas a HELOC acts as a revolving line of credit that you can pull from.
Generally, a home equity loan is a good choice if you need a specific amount for a project, like a renovation. A HELOC is a good choice if you want flexibility or aren’t sure how much cash you’ll need.
What are the advantages and disadvantages of a home equity loan?
Home equity loans are a great way to get low-cost funds out of the value of your home. They generally have low interest rates and can be used to make valuable updates to your home or pay off other debts. The biggest risk is that they use your home as collateral, which means you can lose your house if you default. And since home equity is tied to market fluctuations, a home equity loan may become a liability if the housing market declines.
Does a home equity loan require an appraisal?
Yes, a borrower will want to know how much a home is worth so they know how much equity you have in the home. Knowing your home’s value is how a lender knows how much to loan you—and how much you can likely pay back.
How many years do you have to pay back a home equity loan?
The term of a home equity loan is set by the lender based on a number of financial factors, but most are between five and 20 years, with some going as long as 30.
Thinking about a home equity loan or HELOC?