Your Guide to Home Equity and HELOC
Knowing the Difference Can Make Your Big Dreams an Affordable Reality
When it comes to debt or large expenses, there are a lot of options. If you own your home, you may be able to utilize a low-interest Home Equity Loan or a Home Equity Line of Credit (HELOC). These can be better alternatives to high-interest credit cards or other loans as the rates are often lower and terms more flexible. Today we’re going to cover each type of loan, including their risks and benefits.
What is Equity and How is it Calculated?
Home equity is the value of your home minus what you owe on your mortgage. Your equity increases as you pay down your mortgage and as the value of your home increases.
To calculate your equity, you need to discover your home’s current market value and subtract how much you still owe on your mortgage. For example, if your home’s current value is $450,000, and you still owe $250,000 on your mortgage, you have $200,000 in equity.
Few lenders will allow you to borrow your home’s full equity value. Instead, they will likely allow you to borrow between 75-90 percent (loan-to-value ratio) of your equity. The ratio you receive on your loan is determined by the lender’s policies, how much you owe on your mortgage, your credit score, and your current income.
Based on $200,000 in equity with an 80 percent loan-to-value ratio, you could qualify for a $110,000 home equity loan. Use the Rivermark Home Equity Line of Credit calculator to determine how much you could borrow.
Home Equity Loan vs HELOC
For most people, home equity is a large portion of their financial worth. It’s no surprise that many people utilize equity through either a HELOC or a Home Equity Loan.
Home Equity Loan
Home Equity Loans are sometimes called a second mortgage. If you decide to do a Home Equity Loan, you will have two monthly payments, your actual mortgage and then the equity loan payment. Some lenders will combine the two into one monthly payment to make your life easier.
- Fixed interest rates
- Lower interest rates than personal loans or credit cards
- Stability with fixed monthly payments
- Provided in one lump sum
- Use the money for anything
- Some lenders offer lower fees and costs
- Your home is at risk because it is used as collateral for the loan
- Higher interest rates than HELOCs
- Most lenders charge closing costs and fees
All of the familiar things affect your potential interest rate on your loan such as your credit score, your home’s market value, and your income.
Home Equity Line of Credit
Instead of a lump sum of cash, a HELOC is more like your own personal credit card. Your lender will provide you with a max line of credit that’s available for you to withdraw money as you need it during your ‘draw period’. This usually ranges between 5 to 10-years.
- Lower interest rates than home equity loans
- Flexibility in how much you borrow and when you borrow
- Interest doesn’t accrue until you draw the money
- Faster approval process
- Variable interest rates
- Payments can vary month to month due to the variable interest rate
- Easy access to funds can make it easier to spend more than you need
- Requires an initial advance when loan begins
- Minimum withdrawals when you dip into the line of credit
Most lenders allow flexibility in your draw and payment periods. Since it is a line of credit, many lenders let you to pay the principal before the draw period ends, which can save you money on interest charges.
Best Uses for a Home Equity Loan
When you need money for a large purchase or other one-time expense, using Home Equity can be a great option. Best uses for a Home Equity Loan or a HELOC include:
- Invest in low-cost home improvements by updating but not fully remodeling your bathroom or kitchen
- Replace old garage doors or front doors with new ones
- Invest in your curb appeal to increase your home’s resale value and increase equity
- Debt consolidation can help you put your debt into one loan and reduce your overall interest rate
- College tuition and other education expenses
Most people who decide to leverage their equity use it to build equity through much-needed home updates. However, you will want to minimize the amount of loan you take out by pinpointing low-cost updates instead of full remodels.
When inquiring with different lenders, it is wise to compare the costs of home equity loans. Some lenders charge prepayment penalties or cancellation fees on HELOCs. Others will charge an annual fee and/or an inactivity fee if you do not use your line of credit.
Home equity loans can come with closing costs and fees that range from 2% to 5% of the loan amount. If you take a loan of $110,000, you could pay up to $5,000 in costs and fees! It’s best to talk to your lender and read the fine print. At Rivermark, we offer equity options with no annual fees and no prepayment penalties.
What is a Home Equity Line of Credit?
Have you heard the phrase “home equity line of credit” or seen the abbreviation HELOC but have no idea what they mean? It can be confusing. But at Rivermark, we want to make finance easy to understand. That’s why we’re going to explain what a home equity line of credit actually is and when you should apply for one.
Home Equity Loan vs. Home Equity Line of Credit
It’s important to first note that there’s a difference between a home equity loan and a home equity line of credit. When you take out a home equity loan, you’re borrowing money in a lump sum. This means you get the entire amount of money at once. With this loan, the interest rate is usually fixed. When you take out a home equity line of credit, you have a maximum available amount that you can take money from multiple times as needed. This maximum amount tends to be about 85 percent of your home’s value minus the amount you owe (that is, your mortgage). If you’re interested in what your home equity is, use our easy calculator. HELOCs tend to have an adjustable interest rate.
If you need a large amount of money at once or if you want an interest rate that stays the same, then taking out a loan may be better for you. However, if you prefer to take out the money as needed, rather than as a large lump sum (and don’t mind an adjustable interest rate), a home equity line of credit may better suit you.
At Rivermark, we offer both options. Our home equity loan will let you borrow a predetermined amount of money that you can use as you wish. You then repay this loan on a fixed, monthly schedule. If you choose the home equity line of credit, you’ll receive a credit line that’s revolving. It will give you unlimited access to the credit line until you hit your available credit limit.
When Should I Get a Home Equity Line of Credit?
In most cases, in order to qualify for a home equity line of credit, you need to have a debt-to-income ratio in the lower 40s or under. You’ll also need a home value that’s at least 15 percent more than you owe and a credit score in the range of 620 or higher. If you meet these criteria, you shouldn’t have an issue receiving the line of credit.
If you’re at the risk of foreclosure (that is, if you won’t be able to make the monthly payments), you shouldn’t take out a home equity line of credit. Most people choose to get HELOCs when they’re repairing or renovating their homes, which should increase the value of their homes in the long-run. Additionally, if you do use your HELOC to buy, build, or improve your home, the interest may be tax-deductible.
Another reason to get a HELOC is to pay for education.
When Should I Not Get a Home Equity Line of Credit?
When it comes to other major expenses, such as cars or vacations, it isn’t recommended, as those major purchases aren’t an investment and won’t allow you to build further wealth.
Similarly, if you’re thinking about taking a HELOC out for your basic, everyday purchases to help make ends meet, it’s not a good reason either. Whereas the extra money may be tempting and extremely beneficial, it can be risky to take out a HELOC, as you may, in turn, get yourself into more debt if you’re unable to make the payments.
Furthermore, you also shouldn’t take out a home equity line of credit if:
- Your income is unstable
- You don’t need to borrow that much money
- You can’t afford the upfront costs that come with a HELOC
- You can’t afford the potential for the interest rate to increase
It could do more harm than good, and you should look into other options. Some of the upfront costs can include an application fee, an appraisal fee, a title search, and even attorney’s fees. All of these costs should be taken into consideration because you need to be able to pay them fully if you choose to get a HELOC.
Impact on Credit Score
The impact on your credit score can vary, but some credit bureaus won’t treat HELOCs like a revolving line of credit. If they’re of a certain size, they’ll treat them more like installment loans. This could actually have less of an impact on your credit score than maxing out your credit card would. Of course, it will still affect your credit score by reducing it temporarily; however, the effect might not be as bad.
As mentioned above, your credit score is important in terms of determining whether you’ll be eligible for a HELOC. Be sure to check your score before applying for one to make sure that it’s around 620 or higher.
A home equity line of credit is a good idea in some cases, but it’s not for everyone. It can also be easily confused with a home equity loan, though the two are distinctly different. One works better for some people and situations, and the other works better for others. It all depends on your needs and your finances. It’s important to understand the difference between the two before you decide which one is best for you. You also want to be sure you’re getting a HELOC for the right reasons and not simply for everyday expenses.
If you’re still unsure whether a home equity line of credit will work for you, feel free to connect with us at Rivermark, and we can answer your questions. If you think you’re ready to take out a HELOC, you can apply online with us today.
What Are the Risks of a Home Equity Loan?
Do you need money for a big expense coming up? It can be as varied as necessary home repairs, such as a new roof; paying for a wedding or an unexpected hospital stay; a lavish vacation; or paying off a student loan. If you have equity in your house, you can use an equity loan to take out money for your own use for … anything!
The equity in your home is a simple calculation. How much is your home worth? How much do you owe on it? Subtract how much you owe from the total amount your home is worth. If your home is worth $250,000 and you owe $150,000 on it, then the equity on it is $100,000.
You want to be absolutely sure that the risks don’t outweigh the benefits of this type of loan, though. Maybe you want that lavish vacation, but your credit card bills are maxed out. Maybe it’s best to focus on the credit cards before the vacation—but you can also use the home equity loan to pay off the credit cards and other bills. Just make sure you don’t let the cards get out of control again.
Here are the major home equity loan risks for you to consider.
Your Home Could Be at Stake
There’s an element of risk here because your home is the collateral. In the absolute worst-case scenario, you can lose your home if you’re unable to make the monthly payments. This is why the lender doesn’t often care what you’re going to use the money for. Since you put the house up as collateral, they can foreclose on it if you’re not able to make payments on it. If you lose your job or if other bills pile up, this could mean the lender takes your home. The lender may also charge late fees for late payments, but that could be the least of your worries.
You’re Taking on More Debt
If you have no other way to pay for essential things—your only car was totaled and there’s no public transportation in your area, or you had a sudden emergency medical expense, or your roof is leaking and needs to be replaced—it may be necessary. You may be given relatively favorable interest rates, but at the end of the day, it’s more debt to add to your name (and your finances). Your monthly payments will increase. There may be more interest to pay. Make sure you can pay that extra amount each month and that you’re aware of how much longer it may take to pay off the first mortgage.
You’ll Still Have to Pay the Closing Costs and Fees
These vary but can be between 2 and 5 percent of the loan amount itself, and there may be an early termination fee if you pay off the loan ahead of schedule. When you speak with a professional at your financial institution, make sure they outline if there are any other costs or fees you can expect. Remember, too, that if you start paying back the balance but can only make the minimum payment, you’re not really making any progress. It’ll be difficult to pay it off that way.
What If You Go Underwater?
If your home’s value declines after you’ve already tapped into your equity, you could end up owing more on your home than what it’s actually worth. This term is also known as being “upside-down” on your mortgage. This was a common occurrence in 2008 during the mortgage crisis, and standards have been changed to try to prevent that type of situation, but it’s still a possibility.
Equity Reduction on Your Home
If you take the equity out of your house, it’s like taking money out of your credit union that you’ve already paid. You can use that money, but in the end, your house may be worth less. If you sell the house in the future, you may walk away with less in your pocket than you’re expecting since you’ve had to pay off two loans instead of one. You’ll also have to pay off additional principal and interest each month, which means it will take a lot longer to pay off the first loan.
The Hit to Your Credit Score
If you make frequent late payments, or if you lose your house due to foreclosure, it can show up on your credit report. Future landlords, car dealerships, or even employers might balk at doing business with you if they see you’ve lost a home. A foreclosure can drop your credit score dramatically, between 85 to 105 points if you had an average score beforehand, or between 140 to 160 points if your score was excellent before the transaction. A foreclosure will stay on your credit report for seven years from the date of the first missed payment.
If you receive a home equity line of credit (HELOC), you’ll have a little more flexibility, but there are still some risks involved. Instead of receiving the money in one lump sum, as with a home equity loan, with a HELOC, you’ll receive a line of credit with an approved amount from which you’ll be able to borrow as needed. This is helpful for times when you’re unsure of the total need, such as when you start up a new business or if you want to remodel the house. You’ll only pay interest on HELOCs on money that’s withdrawn, so if you get a HELOC but never use it, you’ll never pay any interest on it. The (albeit smaller) risk on a HELOC is that the lender can cancel the line of credit, possibly before you’ve used all the money.