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Owning real estate is a fantastic way to grow your wealth over time, but there are also other perks of homeownership, including accessing your home’s equity when extra cash is needed to cover large expenses. Your equity represents the value of your home minus what you still owe on your mortgage, as well as any other liens that may be present on your property. Your equity is basically what you own outright.
Tapping into the equity in your home can be done in a couple of different ways, a home equity loan and a home equity line of credit (HELOC). In this article, we’ll go over what these two programs are and which one may be better suited for you and your situation.
Do you know how to build home equity? Check out this article to learn how.
Home Equity Loan – Defined
A home equity loan is a financial product that lets you access the equity in your home. Like a typical installment loan, a home equity loan will provide you with the funds requested in one lump sum, which will then need to be paid back in fixed installments, plus interest. You’ll also have a fixed payment schedule which will detail when your payments must be made.
Terms can range from one lender to another regarding how long you have to pay the borrowed equity back. Like a typical mortgage, your home collateralizes a home equity loan, which means that if you default on your home equity loan payments, your home will be on the line.
The amount that you can borrow against your home with a home equity loan will depend on how much equity you actually have as well as what the lender is willing to offer you. Generally speaking, homeowners must have at least 20% equity in their home before they’re able to take out this type of loan, which means you may be able to borrow as much as 80% of your home’s value. Some lenders might let you borrow more, but the interest rate would likely increase the higher the loan amount is.
- Fund large expenses
- Predictable fixed monthly payments
- Fixed interest rate
- Can be used to consolidate debt and lower interest rates on existing debt
- Your home is at risk if you default
- Higher rates compared to HELOCs (though lower compared to other loan types)
- Costs and fees
When is it Best to Use a Home Equity Loan?
There are plenty of situations where it would make sense to consider a home equity loan. You can essentially use the funds from this type of loan for just about anything you need, though certain expenditures are better than others.
Perhaps the best use of a home equity loan is to cover the cost of a renovation. If the project you choose to undertake will increase the value of your home, that is money well spent. Many projects will bring in a decent ROI that will allow you to recoup most or all of your money spent – and even more – depending on how much value is added as a result.
Another common reason why homeowners tap into the equity in their home through a home equity loan is to consolidate their debt (for more information about using your home equity to consolidate debt, click here). Since home equity loan interest rates are typically lower than typical personal loans (because your home’s equity is collateralizing a loan), you can use the money from your home’s equity to pay off all other debt you may have, including high-interest debt. By securing a lower rate and trading in several loans for just one, you can both save money and make managing your debt easier with just one loan.
Of course, you can always use the money from your home’s equity to pay for an emergency expense, such as a last-minute car repair. That said, it’s important to be careful about what you spend the money on. You don’t want to add to your debt load in the name of frivolous expenditures. Your house is on the line, so you want to make sure you’re using the money wisely and are able to repay the loan amount as required.
HELOC – Defined
A home equity line of credit (HELOC) is similar to a home equity loan in that the money borrowed is coming from the equity in the home. However, the big difference is that HELOCs are a form of credit line that allows you to access a certain amount of equity in your home similar to having access to a credit amount on a credit card.
With a HELOC, you have a set credit limit that you are allowed to borrow against whenever the need for extra cash arises. As long as you have that credit available, you can borrow against it as needed, just like a credit card. Of course, you don’t have to borrow against it at all and can have months or longer elapse between withdrawals. But the credit will always be there when you need it.
The interest rates associated with HELOCs are usually low because your home equity is being used as collateral, which lowers the lender’s risk. You’re only charged interest on the amount withdrawn rather than the entire credit limit, and once you repay the amount withdrawn and no longer owe anything on the credit line, no interest will accrue.
The credit limit for a HELOC is determined by the value of your home and how much you still owe on your mortgage, much like with a home equity loan. The higher your loan-to-value ratio (LTV), which is your outstanding loan amount relative to the value of your home, the higher the chance of you defaulting on your payments. As such, the interest rate might be higher, or the lender might require a lower LTV before approving you for a HELOC.
- Only pay interest on the amount withdrawn
- Access funds whenever you need them
- Great flexibility
- No need to apply for a new loan every time you need extra cash
- Lower interest rate compared to other loans because your home collateralizes the loan
- Your home is at risk if you default
- More difficult to budget for payments
- Interest rates could increase
- Self-discipline is required to make payments
- Credit limit could be reduced by your lender at their discretion
When is it Best to Use a HELOC?
A HELOC is a very unique type of financial product that doesn’t come with a lump sum payout that you must repay on a regular basis like conventional loans. As with home equity loans, the funds obtained through a HELOC can be used for any number of situations. The funds can be used to make updates on your home, make car repairs, or even take a vacation or invest in a lucrative opportunity.
However, a HELOC is better suited for those who may have sporadic expenses that may require a little financial assistance. Rather than having to apply for a new loan every once in a while, the funds from a HELOC are always available. All you need to do is withdraw the exact amount of money needed to cover an expense and only be charged interest on that amount. Once that money is repaid, you can access it over and over again as you see fit.
Should you use your home equity to pay off credit card debt? Find out here.
Home Equity Loans Vs HELOCs: Which is Best For You?
The loan type you choose will depend on your particular situation. If you’re in need of a one-time loan to cover a large expense, such as to pay for a home renovation, and you like the idea of predictability, then perhaps a home equity loan might work best for you. On the other hand, if you need access to extra funds from time to time and don’t want to have to apply for a new loan every time, then the flexibility of a HELOC might be more appropriate.
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