Owning a home comes with a significant advantage of building equity over time. This equity can be used to cover expenses such as home improvements or unexpected bills.
There are two popular options available to homeowners, namely a home equity line of credit (HELOC) and a traditional second mortgage (also known as a home equity loan).
Although both options allow you to borrow against the equity in your home, there are key differences between the two.
What is A Home Equity Line of Credit (HELOC)
A home equity line of credit, or HELOC, is a revolving line of credit that allows you to borrow against the equity in your home. Think of a credit card but your home being the collateral.
How Does a Home Equity Line of Credit (HELOC) Work
The credit limit is determined by the equity in your home, typically up to 80% of the combined loan-to-value. You can borrow up to that limit at any time during the draw period.
The draw period is the time during which you can borrow money from your HELOC. Usually, this period lasts for 5 to 10 years, and you can borrow funds up to your credit limit as needed.
During the draw period, you only have to pay back the amount you borrowed along with any interest that has accrued. In most cases, you don’t have to make any principal payments during this time.
The repayment period is when you must pay back the balance of the loan along with any interest and fees. This period usually lasts between 10 to 20 years and is based on your loan terms.
During the repayment period, you can no longer borrow funds from your HELOC, and you must make regular payments on the amount borrowed. Your payments may be higher than during the draw period as you’re paying back the principal balance and any accrued interest.
If you want to change your loan terms, refinancing your loan is an option. Refinancing involves paying off the balance and starting a new loan with different terms.
Advantages Of a Home Equity Line of Credit
Lower Interest Rates
HELOCs typically have lower interest rates than credit cards, second mortgages and personal loans, making them an attractive option for those who need to borrow money.
HELOCs provide flexibility in borrowing, as you can draw funds as needed and repay the balance at any time. This feature is particularly helpful if you’re not sure how much money you’ll need or when you’ll need it.
The interest you pay on a HELOC may be tax-deductible if you use the funds to improve your home. Check with your tax advisor to see if you qualify for this deduction.
Disadvantages Of a Home Equity Line of Credit
Risk Of Losing Your Home
A HELOC is secured by your home, meaning that if you fail to make payments, the lender can foreclose on your home. This risk makes it important to carefully consider your ability to repay the loan before taking out a HELOC.
Variable Interest Rates
HELOCs typically have variable interest rates that can change over time. This means that your monthly payments may increase or decrease depending on changes in the market.
Like a credit card, without discipline, you can easily overspend while having access to a large credit line, tapping out the equity in your home.
How Traditional Second Mortgage (Home Equity Loan) Compares
A traditional second mortgage is a fixed-rate loan that you take out against the equity in your home. The loan is paid out in a lump sum, and you make monthly payments on the principal and interest over a set period, usually between 10 and 30 years.
Advantages of a Traditional Second Mortgage
Fixed Interest Rates
A traditional second mortgage comes with a fixed interest rate, meaning that your monthly payments will stay the same throughout the life of the loan. This can make budgeting and planning easier.
With a traditional second mortgage, you receive a lump sum payout at the beginning of the loan, which can be useful if you have a specific expense to cover.
Potentially Larger Loan Amounts
Depending on the equity in your home, a traditional second mortgage may allow you to borrow more money than a HELOC.
Disadvantages of a Traditional Second Mortgage
Higher Interest Rates
Traditional second mortgages typically have higher interest rates than HELOCs, which can make them more expensive over the life of the loan.
Unlike a HELOC, where you can draw funds as needed, a traditional second mortgage provides a lump-sum payout, which can be less flexible and limit your borrowing options.
The closing costs for a traditional second mortgage are similar to what you would pay for a first mortgage, about 2% – 5% of total loan amount.
How to Qualify for A HELOC
Equity In Your Home
Equity is the difference between the value of your home and the outstanding mortgage balance. Lenders will require an appraisal, either a physical, drive-by or desktop, to determine the value and equity of your home.
Good Credit Score
Your credit score is an important factor in the qualification process for a HELOC. Most lenders require a credit score of at least 620 to qualify for a HELOC.
Lenders also consider your income when determining your eligibility for a HELOC. You must have a stable income to demonstrate that you can make the monthly payments on the loan.
Debt-to-Income Ratio (DTI)
Most lenders require a debt-to-income ratio of 43% or less to qualify for a HELOC.
Good Payment History
Lenders will review your payment history on your existing mortgage and other debts. A good payment history demonstrates your ability to manage your finances and pay your bills on time.
How to Find Best HELOC Program
Shop Around for Lenders
Just like with any other type of loan, it’s important to shop around and compare offers from multiple lenders. Different lenders may offer different interest rates, fees, and repayment terms. Get quotes from at least three lenders to compare.
Check with Your Current Mortgage Lender
If you already have a mortgage with a lender, it’s worth checking to see if they offer HELOCs. Some lenders offer discounts or other incentives for existing customers. Plus, you may be able to avoid certain fees, such as appraisal fees, by using your current lender.
Consider Credit Unions
Credit unions are not-for-profit financial institutions that may offer lower rates and fees than traditional banks. If you’re a member of a credit union, check to see if they offer HELOCs. If not, consider joining one to take advantage of their lower rates and other benefits.
Check for Promotions
Lenders and Credit Unions offer promotions or special rates for HELOCs at certain times of the year. Check to see if they have any current promotions that could save you money. Just be sure to read the fine print and understand the terms and conditions of the promotion.
Improve Your Credit Score
Your credit score is a key factor that lenders consider when setting the interest rate on your HELOC. A higher credit score can lead to lower interest rates and better terms. Take steps to improve your credit score, such as paying bills on time and reducing debt.
Choose a Shorter Repayment Term
HELOCs typically come with a draw period, during which you can borrow funds, and a repayment period, during which you must repay the loan. Shorter repayment terms generally come with lower interest rates, as they pose less risk to lenders. Consider choosing a shorter repayment term if you can afford the higher monthly payments.
Consider a Fixed-Rate Option
Most HELOCs come with variable interest rates that can change over time. However, some lenders offer fixed-rate options that provide a set interest rate for the life of the loan. Fixed-rate HELOCs can provide peace of mind and predictable payments, but they may come with higher interest rates than variable-rate HELOCs.
A home equity line of credit can be an excellent option for homeowners who need to borrow money. With lower interest rates and flexible borrowing options, a HELOC can be a cost-effective way to finance home improvements or other expenses.
However, it’s important to consider the risks involved and budget for the new monthly payment, especially if it’s going to be an adjustable rate