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Buying a home is often considered superior to renting one because mortgage payments build home equity, an asset you can convert back to cash in various ways. One popular way to tap into your home equity is to borrow against it using home equity loans and HELOCs, short for home equity lines of credit.

If you’re a homeowner, here’s everything you need to know about these two forms of financing.

What is Home Equity?

Home equity is the portion of a home’s current market value that you own free and clear. In other words, it’s typically the difference between your house’s price and its remaining mortgage balance. If you sell your property, your equity would be your net proceeds.

Your home equity should steadily increase as you pay down the balance of your mortgage. However, it can also fluctuate with the value of your house due to the growth or decline of your local housing market.

👉 For example

Say you buy a house worth $300,000. Your 20% down payment is $60,000, and your mortgage balance is $240,000. At this point, your $60,000 down payment would be your only equity in the property.

Five years later, you’ve paid down the mortgage balance by $20,000, and the property value has increased by $40,000. As a result, your new home equity would be $120,000.

What are Home Equity Loans and HELOCs?

Home equity loans and HELOCs are both forms of home equity financing. They let you tap into the equity you’ve built up in your home and use it as collateral for your credit account.

The primary difference between home equity loans and HELOCs is their structures. A home equity loan is an installment account like a mortgage, while a HELOC is a revolving line of credit that functions more like a credit card.

Because both types of accounts require that you use your house as collateral, they often come with relatively generous terms, including lower than average interest rates.

👉 For example: The average home equity loan and HELOC interest rates at the end of 2021 were 5.96% and 4.27%, respectively[1]. Meanwhile, personal loan interest rates averaged 10.28%, and those with less than excellent credit paid even more[2].

In addition, it may be easier to get home equity financing than an equivalent unsecured account. Your equity serving as collateral makes lenders feel more secure. As a result, home equity financing can be a valuable tool for expensive or long-term endeavors like home improvements and debt consolidation.

Those advantages come with a risk, of course. If you can’t pay the loan you could lose your home.

How Does a Home Equity Loan Work?

A home equity loan is an installment debt that functions as a second mortgage, and people often refer to it as such. If you qualify, your lender gives you a lump sum that you pay back in monthly installments over the life of the loan, starting immediately.

Like traditional mortgages, home equity loans typically have fixed interest rates and extended repayment terms. The term can be anywhere from five to 30 years. However, your actual loan terms depend on your credit score, principal balance, and lender.

📗 Learn More: If you want to pursue home equity financing, a great credit score will help you get approved at the interest rate you want. Learn how to raise your score: 5 Ways to Build and Improve Your Credit Score Fast

How Much Can You Borrow with a Home Equity Loan?

Home equity loans usually let you borrow around 80% to 85% of your home’s value when combined with your other outstanding mortgage debt. In other words, lenders are willing to give you a home equity loan that resets your home equity to no less than 15% or 20%, though it varies somewhat depending on your credit score.

Lenders typically express this requirement as a maximum combined loan-to-value (CLTV) ratio. That equals your total outstanding mortgage and home equity loan balances divided by your home’s current market value.

👉 For example

Say you buy a house for $400,000 by putting down $80,000 and financing the remaining $320,000 with a mortgage. Five years later, you’ve paid down your mortgage balance to $280,000, and your house’s value has increased to $450,000.

At that point, you have $170,000 in home equity, $280,000 in mortgage debt, and a $450,000 property value. Your current CLTV ratio would be $280,000 divided by $450,000, which equals 62%.

You want to improve your house, so you decide to take out a home equity loan. Your lender tells you that they’ll let you have a maximum CLTV of 80%.

To calculate your maximum home equity loan amount, multiply 80% by your $450,000 home value to get $360,000, then subtract your current mortgage balance of $280,000 to get $80,000.

To double-check your math, divide your home equity after the new loan by your home value. It should equal the inverse of your CLTV, which is 20% in this case.

For example, your $170,000 home equity before the loan minus the $80,000 of new debt equals $90,000, which is 20% of your current $450,000 home value.

Home Equity Loan Pros and Cons

Using a home equity loan is a significant decision with long-lasting financial repercussions. Here’s what you should know about the pros and cons involved before applying for one.

✔️ Pros

  • Large lump sum available to fund significant projects
  • Fixed interest rates and monthly payments are easy to budget for
  • Lower interest rate than many other installment loans
  • Use the funds for many different purposes
  • Loan interest is an itemized tax deduction if used to improve the home

Cons

  • Closing costs can be high, reducing interest savings
  • Immediate and significant reduction of your home equity
  • Market fluctuations can cause you to owe more than your house is worth
  • Lenders can foreclose on your house if you default on your debt

As you can see, there’s a lot to consider before you take out a home equity loan. Ultimately, the primary reason to take out a home equity loan is to borrow a significant lump sum at a relatively low interest rate that you can use for whatever you need.

Meanwhile, the most significant downside to these loans is the increased risk involved. Taking out a second mortgage eliminates the equity you’ve built and increases the likelihood that a drop in its market value could put you underwater.

⚠️ If you owe more than the house is worth, you’ll have to take a loss to sell the property. That can keep you stuck living in the home, even when you’d prefer to leave. In addition, defaulting on the account could result in foreclosure.

How Does a HELOC Work?

HELOCs are generally considered a form of revolving debt like credit cards. Your lender gives you a credit limit that you can borrow against whenever you need it. Once you pay back what you owe, you can reuse the funds.

However, unlike credit cards, HELOCs have a finite lifespan, and they don’t remain a revolving credit account the whole time. Instead, they have two distinct phases: a drawdown phase and a repayment phase.

The drawdown phase often lasts around ten years, during which the account functions as explained above, and you usually only have to make variable interest payments. However, you’ll have to repay the principal if you want to reuse the funds.

Once you enter the repayment phase, you no longer have the ability to borrow against the account. In addition, your lender will require that you start making fixed monthly payments to pay back whatever outstanding balance remains.

👉 For example

Say you take out a $40,000 HELOC with a 5% interest rate and a 10-year drawdown phase, during which you spend the whole balance on home improvements.

You make $166 interest-only payments each month for a year, then pay the balance off in full to reduce your costs, which takes you another three years.

You’re now four years into your 10-year drawdown phase with a paid-off balance when your interest rate drops to 3.5%. As a result, you decide to make more improvements to your house and max out the account once more.

This time, you make $116 interest-only payments monthly until the drawdown phase ends. Finally, your lender increases your minimum monthly payment to $480 to include principal paydown, and you eliminate the balance over the next 10 years.

For more information on HELOCs, see this useful brochure from the Consumer Financial Protection Bureau.

How Much Can You Borrow with a HELOC?

Like a home equity loan, a HELOC typically lets you borrow up to around 80% or 85% of your home’s current market value when combined with your outstanding mortgage balance.

However, because you can withdraw and repay your HELOC as much as you want during the drawdown phase, you can potentially receive more capital using a HELOC than a home equity loan.

HELOC Pros and Cons

Like home equity loans, HELOCs are significant credit accounts that you shouldn’t take out on a whim. Though they can be powerful, borrowing against your home equity is always risky. Here are the factors to consider before doing so.

✔️ Pros

  • Loan interest is an itemized tax deduction if used to improve the home
  • Interest-only payments during the drawdown phase
  • Potentially lower interest rate than other lines of credit
  • Use the funds for many different purposes
  • Loan interest is an itemized tax deduction if used to improve the home

Cons

  • Interest rates are typically variable
  • Closing costs can be high, reducing interest savings
  • Market fluctuations can cause you to owe more than your house is worth
  • Lenders can foreclose on your house if you default on your debt

Unsurprisingly, the pros and cons of HELOCs are similar to those of home equity loans. The two financing options have a lot in common, with the most significant differences being their respective structures and interest rate behaviors.

Generally, they make sense when they’re well within your ability to repay, you’re using them for something financially responsible, and the risk of you being underwater is low.

👉 For example, it might be beneficial to take out a modest HELOC or home equity loan to convert a small storage space in a long-term home into an additional bedroom.

It should drive up the property value, and your interest might be tax-deductible. In addition, because you’re not planning to leave anytime soon, there’s not much risk of getting trapped by a debt that exceeds your property value.

📗Learn More: Have you ever thought about renting out one of your spare bedrooms for some extra cash? Take a look at our analysis of the strategy: What is House Hacking and Should You Try It?

Where to Get Home Equity Financing

If you’re interested in home equity financing, a great place to start your search is with the lender holding your existing mortgage if you have a good relationship.

However, that shouldn’t be your only stop. Like with mortgages, it’s essential to shop around with multiple lenders to get the best home equity loan or HELOC. Try reaching out to other banks, credit unions, and mortgage companies.

A good rule of thumb is to get between three and five offers. That will ensure that you have an accurate understanding of the options available and helps you negotiate from a position of strength.

Finally, make sure you review the offers in detail. Don’t just go for the one with the lowest interest rate on the sticker. Details like closing costs, ongoing fees, and repayment terms significantly impact your total borrowing expenses.

If you want help, it may be worth working with a mortgage broker to guide you through the process and explain the specifics of each option’s terms.