Tapping into the equity in your home is a common way to access cash for everything from home renovation and debt consolidation to college expenses—at much lower interest rates than personal loans and credit cards. With recent dramatic increases in home prices, many Americans have significantly more value in their homes than they did just a few years ago. In fact, for homeowners in the Quad Cities, home values have increased from about 19 to 25 percent in the past five years alone.
Home equity loans and home equity lines of credit (HELOCs) are similar financial mechanisms in that they both allow you to borrow against the equity in your home—the value of your home minus the balance of all mortgages and loans you have out on it—and pay back the amount you borrow over an extended period of time. However, because of the different ways in which cash is accessed and repaid with each one, they are often used and most useful for different purposes.
The largest benefit of both home equity loans and lines of credit is that interest rates tend to be low because the debt is secured by your home. This can save you a lot of money over unsecured loans and credit cards, making them smart approaches to managing debt and accessing cash when you need it. But using your home as collateral is also the source of their biggest drawback: you are not only reducing your stake in your most valuable asset, if you fail to make payments, you could face foreclosure. That’s why it’s important to understand the ins and outs of both choices and review all your options with your bank to determine if a home equity loan or line of credit is right for you. This post will get you started; keep reading to learn more about each type of loan, their individual pros and cons, and the best ways to use them to manage finances and save money!
What is a Home Equity Line of Credit (HELOC)?
A home equity line of credit is much like a credit card, where you have a revolving balance and a borrowing limit which is usually about 80-90% of the equity in your home (not to be confused with total value). Unlike credit cards, which are ‘unsecured’ debt, HELOCs are ‘secured’ by your home—this means that banks have less risk, and therefore they will offer you a lower interest rate. With a HELOC, you borrow chunks of money, a little at a time, as needed, up to your borrowing limit. How do you use the funds to pay for things? There are different ways to access those funds, including online transfers, telephone request, in person request or request by mail.
Our HELOCs draw period and repayment period run concurrently during the term of the loan. There is a required balloon payment at the end of the loan term. Lastly, interest rates are usually not locked (i.e., variable), which means that they fluctuate from time to time with the current market rate. SENB offers both variable and fixed rate options. See a lender for details on how to qualify.
Pros of Home Equity Lines of Credit
Because of the nature of the HELOC—a line of credit secured by your home—there are a lot of benefits over other methods of borrowing money. Some of the biggest ones include:
- Low interest rates. While HELOCs function similarly to credit cards in that you have a revolving line of credit, the interest rates are significantly lower—10% or more on average. Using a debt repayment calculator, you can see how that interest can add up: with an average APR of 16%, a $20,000 credit card debt paid back over six years will cost you over $9,000 in interest alone. With a 6% HELOC, the same amount will not only have lower monthly payments, but could also save you over $6,000 in interest.
- Tax deductible. If you use your HELOC for building improvements (when you “buy, build, or substantially improve” your properties, per the IRS), you can deduct the interest you pay from your tax bill. Consult a tax advisor for further information regarding the deductibility of interest.
- Only borrow what you need. If you aren’t sure about how much money you will need for an ongoing project or expense, you can borrow a little at a time. You only make payments for what you actually borrow, so you can end up with a smaller monthly payment than a home equity loan where you borrow everything at once (see below).
- Flexible repayment options. With minimum payments during the draw period and a total timespan of up to six years to spread out the monthly installments, you can enjoy lower costs each month, or pay back more when you can afford to.
Cons of Home Equity Lines of Credit
Because of their flexibility and connection to the equity in your home, there are a few drawbacks to HELOCs as well:
- Your home is collateral. Though less common than first mortgage foreclosures, if you miss payments on your HELOC and your loan defaults, your home could be at risk.
- Variable interest rates. HELOC rates are tied to the market. As NextAdvisor points out, “your interest rate—and by extension, monthly payment—could change unexpectedly in the future.” When rates go up, your payment could as well.
- Increased risk of overspending. Using a HELOC instead of a high-interest credit card could be a sound financial decision to fund ongoing expenses, especially ones that add value to your home like renovation. But if you have the tendency to spend beyond your income, easy access to cash with small interest-only payments in the draw period can encourage overspending, putting your house at risk if you fail to make payments later on.
Popular Uses of HELOCs
Using a HELOC to pay for everyday expenses might not be advisable, but there are a number of common items that HELOCs are used for that can make smart financial sense. These include:
- Home/Property Improvements. Useful if you will need a little money at a time to pay for ongoing work, rather than one lump sum. Not only will it add value (and equity!) to your home or other property, if you use a HELOC to pay for improvements for the property that is the source of the line of credit, it’s tax deductible, too!
- Children’s Education. Pay one tuition bill at a time, over the course of your child’s education. Rates for HELOCs are often significantly lower than those for Parent Plus student loans, leading to the potential for big savings.
- Medical Bills. If you expect to have a period of ongoing medical expenses, a HELOC can help you cover your bills as they come up. However, be sure to explore all your options before putting your house on the line.
- Retirement Living Costs. If you are retired or approaching retirement, a HELOC can provide cash flow as needed, particularly if there is a downturn in the stock market that affects your income.
- Emergency expenses. Open a HELOC in advance, so you always have immediate financial options should the need arise.
What is a Home Equity Loan?
Your mortgage was essentially a loan for an amount of money equal to the value of your home (minus your down payment), used to pay off the home itself. Home equity loans, often called second mortgages, are loans taken out against the equity in your home, and can be used to pay for anything. Like a first mortgage (and unlike a HELOC), you will have to pay fees or closing costs, meaning that home equity loans are really only worth it if you need a sizable lump of cash all at once.
In order to determine how much money you can qualify for, something called a ‘Combined Loan-To-Value Ratio’ (CLTV) is used. As Pocket Sense explains, a CLTV is the ratio “of the dollar value of all loans that are secured by a certain property to the estimated value of that property,” expressed as a percentage. Generally, banks don’t want the total amount of loans to be more than 80% of the total property value, unless you have really stellar credit.
Home equity loans usually have both fixed interest rates and monthly payments. As opposed to the draw and repayment cycle of a HELOC, you will pay both principal and interest from day one, and terms usually last one to six years depending on how much you are borrowing and how much you can repay each month. Interest rates, while generally comparable to out HELOC rates, are usually a little higher than first mortgages—though this depends entirely on what your current mortgage rate is (for instance, if you get a home equity loan while mortgage rates are low, but your original loan was from when mortgage rates were higher, you could have a lower rate). Ultimately, while sharing the same basic borrowing principles as home equity lines of credit, home equity loans have a distinct structure that makes them appealing for quite different uses.
Pros of Home Equity Loans
If you know how much money you need and value a consistent and predictable repayment plan, home equity loans might be the right choice for you. The most notable benefits of home equity loans include:
- Low, fixed rates. Because they are secured by your home, interest rates on home equity loans will almost certainly be lower than that of unsecured debt like credit cards and personal loans—on average, only 5% to 6% compared to 6% to 36%.
- Fixed, lower monthly payments. Because you can take 1 to 6 years to pay off a home equity loan, coupled with low interest rates, your monthly payment can be quite low. Use myFico’s home equity payment calculator to determine how much yours could be.
- Tax deductible. As with a HELOC, if you use your loan to make improvements to your home, you can deduct the interest from your taxes. Consult a tax advisor for further information regarding the deductibility of interest.
- Use it for anything. There are no rules on what you can use a home equity loan for. Home equity loans are affordable ways to access larger amounts of cash for any reason, at lower interest rates.
Cons of Home Equity Loans
While the lower interest and fixed payments of home equity loans might make them seem more attractive than other kinds of loans, there are some downsides as well:
- Your home is on the line. If you don’t make payments, you could lose your home. Keep in mind that you don’t need to borrow the entire sum that you qualify for. The smaller the loan, the easier it will be to pay back, especially should your circumstances change.
- One lump sum. You will need to know the total amount of money you require up front. Additionally, you will pay interest on the full amount from the first day, even if you don’t use all the money at once.
- Stricter credit requirements. Home equity loans have stricter credit requirements than other kinds of loans, like credit cards. If you don’t have good credit or already have a lot of debt, you might not qualify (even if you plan on using the home equity loan to pay off your debt). If you’re looking to pay off debt but aren’t able to get a home equity loan, you have other options, like debt consolidation loans.
Popular Uses of Home Equity Loans
Common uses of home equity loans often overlap with HELOCs. However, because you get access to the total loan amount at once, versus bit by bit, there are some things where it makes more sense to utilize a home equity loan.
- Home improvements. For home improvement projects that will be completed in a shorter time frame (for instance, a kitchen renovation that lasts a few months), it makes sense to use a home equity loan. Compared to a HELOC, the set loan amount of a home equity loan will not only help you stick to your budget, but will also prevent you from going into further debt for other expenses. Using a home equity loan to add value to your home is probably the wisest use of one.
- Debt consolidation. To pay off high-interest debt, it’s sometimes better to take out a home equity loan than continue paying suggested monthly payments at the original interest rate. You can borrow the exact amount you need to pay off, and not a penny more (as opposed to a line of credit), and get the best interest rates available. To learn more about using home equity to consolidate debt, check out this guide from NerdWallet.
- Business expenses. If you have a business that requires more capital to grow, you might be able to save money on interest by taking equity out of your home instead of taking out a business loan. Because a return on investment in a business isn’t guaranteed, before you commit to taking this action, be sure to run the numbers on your business. Fit Small Business has this useful guide on how and when to use a home equity loan for your business.
- Weddings and big ticket purchases: If you plan on making a single big purchase or have one large upcoming expense, home equity loans might be the most affordable answer. Just make sure that the one-time cost is worth the years of payments and interest (and risk on your home).
- Education Expenses: as with other kinds of debt, home equity loans can be ideal for wiping out high-interest student loan balances. However, because student loans are often backed by the government and have flexible repayment terms, be sure to utilize payment calculators to determine how much money you will save, and if it will be worth it to take out a loan against your home.
Is a HELOC or Home Equity Loan right for you?
If you are interested in learning more about HELOCs and home equity loans, the most important first step is to talk to your bank. Professional lenders like our team at SENB Bank can help you weigh your options, look at your whole financial picture, and help you determine whether a HELOC or home equity loan is the best choice for you.
SENB Bank is proud to serve the Quad Cities and Stateline community, and we work hard to provide you with the best financial solutions that meet your needs. Our Home Equity Loans and Home Equity Lines of Credit offer competitive interest rates right at your local bank, streamlining your finances and saving you money. Contact us or visit your local branch to learn how we can help you apply for a home equity loan or home equity line of credit today!