A home equity loan is a type of secured loan where a borrower uses the equity of their home as collateral for the bank. The amount available is generally determined by the value of the property as determined by an appraiser from the lender. Getting one of these loans means your home has a lien on it and your actual equity in the home is reduced. Borrowing against the equity in your home can be a great way to get a low-cost loan. There are two types of home equity loans: home equity lines of credit (HELOCs) and fixed-rate loans. Each of these have their pros and cons, so be sure to pick the one that’s best aligned with your needs.
Home Equity Loans Definition
A home equity loan, sometimes referred to as a “second mortgage,” offers a way for homeowners to borrow based on the equity they hold in their home. In other words, you can borrow money based on the difference between the current balance of your mortgage and your home’s current value. The equity you hold in your home represents your collateral.
There are two main types of home equity loans, including:
- Home equity line of credit (HELOC): A HELOC lets homeowners borrow money as they need. These are usually variable-rate loans, but they carry a specific term length. Once the term is complete, you must repay what you’ve borrowed.
- Fixed-rate home equity loan: Similar to a standard mortgage, this fixed-rate loan provides you with a single lump sum. As its name implies, you’ll need to make regular payments at a set interest rate for a specific term.
Home Equity Loan and HELOC Benefits
Unlike unsecured loans (such as a personal loan) or credit lines (such as a credit card), you’ll use your home as collateral. This is true of both a home equity loan and a HELOC. This means it will be easier to qualify for your loan provided your remaining mortgage value is less than your home’s value.
On top of this, home equity loans have fairly lax requirements. Home equity loans often call for the homeowner to own at least 15% equity in their home. As far as credit scores are concerned, a score of at least 620 is usually enough for approval. Your debt-to-income (DTI) ratio should be no more than 50%.
You’ll also get lower interest rates with a home equity loan than most other similar options. According to ValuePenguin’s 2023 report, the average rate on 15-year fixed-rate home equity loan is 5.82%.
Beyond this, home equity loans usually let you borrow quite a bit of money. In fact, they can range anywhere from $10,000 up to hundreds of thousands of dollars. You can also use them for just about any purpose. Borrowers may use the money for home renovations, paying off high-interest loans, paying for college and starting a business.
With a home equity loan, the amount of money you can borrow is specific and set in stone. But if you choose a HELOC, you’ll have much more flexibility. This is because you can take out as much as you need, when you need it, up to the limit of the HELOC. Your payments will vary as well.
Home Equity Loan and HELOC Downsides
The big risk with a home equity loan or HELOC is that you could lose your home if you don’t pay it back. The point of a secured loan, after all, is that lenders are more willing to lend to you because they know they can take your collateral if you don’t pay. In this case, the collateral is your home. Don’t risk the roof over your head for a low-cost loan if you have any doubt about your ability to pay it back.
The most obvious limitation for a home equity loan is that those who don’t hold much equity in their home won’t be able to get one. You typically need no less than 15% equity in your home to get a home equity loan. For example, if your home’s appraisal is $200,000, you’d have to owe no more than $170,000. Additionally, those with bad credit or substantial debt likely won’t have access to a home equity loan.
Home equity loans and HELOCs also call for stability. If you expect to sell your house soon or a change in income that would make it hard to pay up, a credit card or unsecured personal loan might be better.
While a HELOC offers nearly instant access to cash, a fixed-rate home equity loan can take a few weeks to dish out your funds.
Interest on home equity loans used to be generally tax-deductible. However, the Tax Cuts and Jobs Act of 2017 eliminated this deduction unless the loan is used to buy, build or substantially improve your home. A financial advisor can help you figure out whether your loan is deductible – and, for that matter, whether it’s even a good idea at all.
HELOCs vs. Home Equity Loans
You can think of a home equity loan as a fixed-rate loan. You borrow a set amount with a predetermined interest rate. So you’d always know what your monthly payment will look like. You’d also know when you will pay it back if you stick to this plan. In fact, the terms on these loans can stretch anywhere from five to 30 years.
A HELOC works more like a secured credit card. You borrow what you need from the equity in your home. You pay interest only on what you borrow. And as you pay it back, you can borrow more up to a certain period of time before you pay it all back. But while some lenders allow fixed-rate HELOCs, most only provide variable-rate HELOCs. This means the interest rate can drop or rise depending on changes to a certain benchmark like the prime rate.
If you have access to a HELOC and a home equity loan, your choice comes down to preferences and financial habits. If you know exactly how much you need to borrow and can make timely payments even if interest rates rise, you may be best with a HELOC. People often use HELOCs to renovate their homes through profitable home improvement projects that increase home value.
But if you’re more comfortable paying off a lump-sum loan with a fixed-interest rate, then a home equity loan may work for you. Some people use low-interest home equity loans to pay off high-interest credit card debt. But a balance transfer card can help you tackle credit card debt often with no interest for a defined period of time.
In addition, many financial planners suggest that the only reason you should take out either one is to use it for something that substantially improves the home’s value such as a successful home-improvement project. A standard, low-interest loan or meeting with a financial advisor may help you pay off debt without tapping into your home equity. Remember, both home equity loans and HELOCs take your home as collateral. So you can lose the roof over your head if you default.
To help you make your decision, you can view the table below which illustrates how both differ.
HELOC and Home Equity Loan Comparison
HELOC vs Home Equity Loan
|Factor||HELOC||Home Equity Loan|
|Interest Rate||Variable and can drop to as low as 4.24% (Some lenders allow fixed-rate HELOCs or taking a portion as a fixed rate)||Fixed rate and can dip to 5.4%|
|Terms||Varies by lender but usually five-to-10 years||Varies but typically five-to-thirty years|
|Fees and closing costs||Varies by lender||Varies by lender|
If you decide to explore a home equity loan, be sure to shop around. Fees, interest rates and qualifying standards vary widely. Check with banks, credit unions, online brokers and local and national loan originators to get the best deal for you.
Once you’ve chosen a lender, gather your paperwork. You’ll need a home appraisal, tax returns, paycheck stubs and perhaps divorce decrees and other documents. After you’ve submitted your documents and receive approval, you’ll have a closing like the closing for your purchase mortgage. You’ll review and sign a thick pile of documents. At the end, you’ll get a check or have the funds transferred into an account.
Home equity loans and HELOCs have many upsides and downsides. Sometimes a credit card cash advance or unsecured personal loan may be a better choice. You may also explore a cash-out refinance loan. This replaces your first lien mortgage with another first-lien mortgage. It can provide another way to turn your home’s equity into cash.
Tips for Buying a Home
- The most important step in the home-buying process is figuring out how much home you can afford. Stop by SmartAsset’s home affordability calculator to set your budget.
- Buying a home and managing your equity in it may prove extremely complicated. A financial advisor can help you fit this into your financial plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Photo credit: ©iStock.com/William_Potter, ©iStock.com/sturti, ©iStock.com/PrathanChorruangsak