One of the primary benefits of homeownership is building equity. This is the value tied up in your home and it increases as you pay down your mortgage and home values rise. You can find out what your current equity is by simply subtracting how much you owe from the current market value of your home. The difference is your equity. It’s a bit like having a savings account for your home. Except that the value is looked up and can’t be accessed until your sell or borrow against the equity. Banks will allow you to borrow like this through either a home equity loan or a home equity line of credit (HELOC). This can very useful if you need emergency maintenance funds or you want to make home improvements. But by doing this you’ll be taking on some financial risks.
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Borrowing on your equity
What differentiates these two types of loans from a personal loan is that the house is the collateral. If you can’t keep up with payments, then you risk going into foreclosure. Also, these two types of “second mortgages” will draw on your equity and thus reduce the value of your home. There’s a real chance that you could end up borrowing more than the home is worth. This is a serious problem if you need to move and must sell. You’ll either end up losing money on the sale or be unable to move at all. Most lenders for both loans will cap the amount you can borrow at 85% of your current equity. Other factors are also considered such as credit score, income and market value in how much you can borrow.
Both of these loans have their own pros and cons, so it is essential to choose wisely. Most financial planners will stress that the only justification for tapping into your equity is to add value to your home. Consider that as you look at the pros and cons of both options.
Home equity loans
A home equity loan is one in which the borrower gets a one-time lump sum. This loan is to be repaid over a fixed term at a fixed interest rate. Meaning that your monthly payments will be the exact same month after month, year after year. This makes it easy to account for in your budget. However, keep in mind you’ll be paying the home equity loan in addition to your current mortgage payment.
- Great as a source of funds for major projects or one-time expenses
- Comes at a fixed interest rate over a set period
- Taking one large chunk out of your equity can work against you if property values decline in your area.
Home equity lines of credit (HELOC)
With a HELOC, you’re given a line of credit which you can draw on over a set period of time. This makes it much like a credit card. The beauty of this is that you’ll only be paying interest on what you borrow. HELOC’s usually start with a lower interest rate than a home equity loan. But they come with an adjustable interest rate which will rise or fall depending on the movements of a benchmark. Meaning your monthly payments will change depending on the interest rate and how much you have borrowed. Some lenders will allow you to carve out a portion of your HELOC loan and set it at a fixed rate. You’ll still be able to draw on the remaining balance at the adjustable rate. Some banks also offer it in two different forms:
- One with an interest-only draw period
- One with a draw period where you pay back interest and principle.
With the latter option, you can pay back the loan sooner. When the line of credit expires the repayments on the principal will begin. Once the outstanding balance and interest are paid back the lender may or may not renew your line of credit.
- You pay interest only on the amount you’ve borrowed
- It may come with the option of paying only the interest during the draw period
- An adjustable interest rate makes your monthly payments unpredictable
- If you’re not careful you can overspend and land yourself with large principle and interest repayments once the repayment period begins.
So which is better?
The answer to this, as with so much else in real estate, is that it depends. One will be better than the other depending on your own personal situation. Think about how much money you’ll need and for what purpose. Consider monthly payments, interest rates, and tax advantages. If you need a large amount to cover expenses now and don’t plan on borrowing again, a home equity loan is better. But if you need cash over a staged period, like for a modeling project that will take three years to complete, a HELOC is the right choice.
The equity in your home can provide ready cash for when you need it. But it will mean taking a risk with a second mortgage that in a worst case scenario can lead to foreclosure. Different banks will also have different policies on these loans, so be sure to ask your lender the right questions so you know what you’re agreeing to. Talk closely with your financial advisor on the best course of action before deciding.