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Some people take out home equity lines of credit or home equity loans to pay for home improvement projects, but these loans have their downsides.
Once you have a certain amount of positive equity in your home, you have the option of borrowing against that equity with a second mortgage, of which there are two main types: a home equity line of credit (HELOC) and a home equity loan. Most people use HELOC and home equity loans to consolidate debt or if they’re in a financial bind and need cash on hand to complete a home improvement project.
The amount of equity you’re given access to is typically 80% of your home’s value less your remaining mortgage balance. If your home is worth $500,000, your home’s maximum lendable value is $400,000. That means if you have a $150,000 mortgage balance, your maximum home equity loan or line of credit is $250,000.
However, HELOC and home equity loans have their downsides.
If you have the option of giving yourself more time to save up for a big expense rather than tapping into your equity, that may be the way to go. With HELOC and home equity loans, you’re essentially taking on a second form of debt that’s attached to your home. That means if you fail to make payments, you could lose your home too.
But if used correctly, HELOC and home equity loans can work out. If you’re deciding between the two, which is better? Well, that depends on a number of factors which we’ll go over in this guide.
In this article:
A HELOC functions like a credit card in that you only take out as much money as you need. You’re also given a maximum line amount, or spending limit, and you can continue to access funds as long as your account is open and you haven’t gone over that limit.
Most lines of credit are variable-rate loans. That means your interest rate can fluctuate over the course of your term. Some credit unions may also offer fixed-rate lines of credit.
Every HELOC is made up of two phases:
To determine your credit limit, your lender will consider your ability to pay back the loan. They’ll look at how much you make, your debt-to-income ratio (how much you make versus any debts you currently owe), and your credit history, among other factors.
Once your credit line is approved and you’ve paid all of the required closing costs, you’ll be able to borrow up to your maximum line amount whenever you want. Your HELOC closing costs will include:
Once your line of credit has been approved, your bank will allow you to make transfers over the phone, online, using special checks, and in some cases they’ll give you a special credit card.
How you repay your HELOC is going to vary depending on your loan agreement and whether you have a variable-rate or fixed-rate HELOC (though it's typically variable), and how frequently you draw out money during the draw period.
You’re going to make monthly payments throughout the term — even during the draw period — like you would with a regular mortgage, but the amount you pay at any given time will depend on your repayment terms.
Depending on your repayment terms, you may make interest-only payments during the draw period followed by higher principal plus interest payments during the repayment period. Or you’ll make principal plus interest payments during the draw period and have to pay off the entire effective balance, or a “balloon payment,” once the draw period ends. Make sure you set yourself up with favorable repayment terms.
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A home equity loan works like a fixed-rate mortgage in that it’s a one-time, lump-sum loan that you pay back over a five- to 30-year term. Home equity loans work best if you need a set amount for a specific purpose, like an addition to your home or an expensive renovation project.
Since home equity loans have a fixed interest rate, you’ll be paying back the same amount each month throughout the loan term. That makes home equity loans a little easier to budget for than the typically variable-rate HELOC.
Before closing on your home equity loan, you’ll submit a number of forms and documents to your bank, which will likely include your W-2s, tax returns, credit card and loan statements, and bank statements. You’ll also have to pay many of the same closing costs as a HELOC to cover expenses associated with the home equity loan.
Before settling on a HELOC or home equity loan, you should figure out how exactly you plan to spend the money and pay it back. For example, if you need the money for a roof replacement for which you were quoted $35,000, a home equity loan might make the most sense since it’s a one-time purchase and you’re getting that fixed interest rate.
(Read more about taking out a home improvement loan.)
But if your expense requires a little more flexibility, like a number of different renovation projects over the course of a year, or if you need to pay off student loans from month to month, the flexibility of a HELOC may work better for you.
If you can get a fixed-rate HELOC at a decent rate, that may be the way to go, as you’re only paying interest on the amount you spend — not the maximum line amount. With a home equity loan, you risk over-borrowing for an expense, and you’re stuck paying interest on the entire loan, not just the amount that you need.
You also risk under-borrowing and having to potentially take out another loan (and paying closing costs all over again), so there’s a little more risk involved with home equity loans, in that sense.
But taking out either a HELOC or a home equity loan may not be the best idea any way you slice it.
Take debt consolidation, for instance, which is a popular use of both HELOC and home equity loans. The thinking goes that, if you have high-interest student loan or credit card debit, you simply repay that debt with a lower-interest HELOC or home equity loan and save yourself money down the road.
The problem with that strategy is, although you’re getting rid of that high-interest debt, you’re simply replacing it with another form of debt that’s secured by your home. That means if you’re unable to make payments, you could lose your home.
Second mortgage closing costs also have a tendency to be super high which alone may not be worth it.
Rather than taking out a HELOC or a home equity loan, consider saving up an extra few months or years using a high-yield savings account rather than tapping into your crucial home equity.
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