Read this before you refinance

If you’re a homeowner wanting to tap into your home’s equity, you might be considering a home equity loan or a home equity line of credit (HELOC). Both allow you to borrow against your home’s value, but they aren’t created equal. For example, a home equity loan pays out one big lump sum of money, while a HELOC offers you a revolving line of credit. 

What’s the difference between a home equity loan and a HELOC?

When you need to access the equity in your home, you have two options: 

While both options sound similar and let you borrow against your home’s value, there are key differences between them that’ll determine which is right for you. Most notably: 

• Interest rates: Home equity loans have fixed interest rates that stay the same throughout the life of the loan. HELOCs have variable interest rates that change over time.
• Loan disbursement: Home equity loans disburse funds to you in one lump sum. HELOCs, on the other hand, offer a revolving line of credit that can be withdrawn from as needed.

Here is how home equity loans and HELOCs stack up against each other: 

Can you get both?

Yes, you can get a home equity loan and a HELOC at the same time. According to Vikram Gupta, head of home equity at PNC Bank:

“One of the most critical factors to consider is your ability to make the additional monthly payments, and comfortably repay both loans, within the specified time frame without overextending yourself financially.” Gupta said. “It’s also important to consider the necessity of both loans and whether they truly align with your financial goals.”

How does a home equity loan work?

A home equity loan lets you borrow against the equity that you’ve built up in your home. Great to help cover large expenses and financial emergencies, these loans pay one large lump sum upon approval. 

You’ll need to pay back your loan in monthly payments with a fixed interest rate. The interest rate that you’ll pay depends on several factors, including your credit score, the amount of equity you’re borrowing against, and your loan amount. 

How to get a home equity loan

To get a home equity loan, you’ll need to meet the qualifications set out by your lender. Each lender’s requirements are different, but usually include:

• A credit score of at least 660. 
• A DTI ratio of 43% or less.
• At least 15% to 20% equity in your home.

Once you’re sure you can qualify, the process is similar to getting a mortgage. You’ll start by comparing home equity loan lenders to find the one with the best rates and terms. Once you do, you’ll follow the lender’s application process and submit relevant financial documents. 

Reasons to take out a home equity loan

There are no restrictions on what you can use home equity loans for. That said, borrowers tend to reserve them for large purchases and emergencies. 

Some reasons why you might choose to take out a home equity loan include:

• Home renovations: Renovating your home can be costly, but a home equity loan can help you finance it. This can increase your home’s value, which could raise your equity.
• Debt consolidation: Instead of having multiple different loan payments, you can pay off those debts with your home equity loan and just focus on one payment.
• Education expenses: If you or your child has education expenses, like college tuition, you can use your home equity loan to cover these.
• Emergency expenses: Financial emergencies, like an unexpected medical bill or home repair, can be covered with the money you receive from a home equity loan.

Calculate your home equity

To figure out how much equity you have in your home, you can follow this simple formula: 

Current home value – outstanding mortgage balance = home equity

For example, if your home is valued at $300,000 but you owe $200,000 on your mortgage, you have $100,000 in home equity. 

It is important to note that many lenders have a maximum loan-to-value (LTV) ratio that they’re willing to loan you, which typically falls around 85% of your home’s value. Additionally, you should be aware that your equity will fluctuate depending on the value of your home in the current housing market. 

Pros and cons of a home equity loan

Pros

• Lower interest rates: Home equity loans carry less risk for the lender since the loan is secured by your home. This can result in lower interest rates than those found on other loan products. 
• Flexibility: Since you can borrow almost all of your home’s equity with a home equity loan with no limits on where it can be spent, it is an easy way to fund large projects and emergency expenses. 
• Fixed monthly payments: Home equity loans have fixed monthly payments, making it easy to manage your loan payments.
• Loan interest may be tax-deductible: In certain cases, home equity loan interest is tax-deductible if you use it for home improvements.

Cons

• You could lose your home: Home equity loans use your home as collateral, so you could lose your home to foreclosure if you can’t afford your loan payments. 
• You may owe more than your home is worth: If the value of your home declines, you may end up owing more on your loan than your home is worth. 
• Longer loan terms: Home equity loans often have loan terms lasting up to 30 years. This could prolong the amount of time it takes you to own your home outright. Plus, this results in more interest paid when compared to other lending options. 
• Fees: Home equity loans often come with fees, such as appraisal fees and closing costs. 

How does a HELOC work?

A home equity line of credit (HELOC) lets you borrow against the equity you’ve built in your home. Unlike home equity loans, which pay out a lump sum, HELOCs offer a revolving line of credit that stays open for a period of time, often referred to as a “draw period.” Typically, draw periods last up to 10 years. 

During the draw period, you can withdraw funds as needed, up to your credit limit. Then, when the draw period ends, you’ll pay back your balance plus interest. On a HELOC, interest rates are usually variable and are based on the prime rate, plus an additional margin determined by your credit score and history. 

How to get a HELOC

To get a HELOC, you’ll need to start by meeting the requirements set out by your lender. Each lender is different, but most usually require:

• Enough equity to cover the amount you wish to borrow.
• A debt-to-income ratio no higher than 43%.
• A good credit history and credit score of 700+.

After you’re sure you can qualify for a HELOC, the process will be very similar to applying for a home equity loan.

Reasons to use a HELOC

HELOCs are flexible and convenient, making them a good option if you’re in search of funding. Here are some reasons why you might consider a HELOC:

• Home improvements: HELOCs’ flexibility makes them great for home projects, especially those that run the risk of going over budget, since you can continue to draw from the credit line. 
• Business expenses: With a revolving credit line, you can cover the costs of starting or growing a business. 

• Emergency funds: A HELOC can be used as an ongoing safety net for emergency expenses, like medical bills and home repairs.
• Education expenses: HELOCs can be used to pay for college expenses that arise over you or your child’s college career. 

Calculate your tappable equity

Like with home equity loans, HELOC lenders have a maximum loan-to-value ratio cap. For HELOCs, this is usually set at 75% to 85%. With that in mind, lenders calculate your tappable equity by using the following formula:

(home value x lender’s loan-to-value ratio cap) – outstanding mortgage balance = tappable equity 

For example, let’s say that your home is worth $400,000, your lender’s maximum LTV for a HELOC is 80%, and your outstanding mortgage balance is $200,000. Using the above formula, you’d have $120,000 in tappable equity.

Pros and cons of a HELOC

Pros

• Flexibility: HELOCs let you borrow money as you need it, rather than all in one lump sum.
• Interest only charged on the amount you borrow: With a HELOC, interest is only charged on the money that you borrow, not the entire credit line.
• Provides a financial safety net: If you’re facing uncertain times, like an unexpected illness, a HELOC can help you cover bills and other expenses as they come up. 
• Interest may be tax-deductible: If you’re renovating your home with the funds from your HELOC, the interest accrued may be tax-deductible. 

Cons

• Variable interest rates: Since HELOCs have variable interest rates, your monthly payment is likely to fluctuate. 
• Your home is collateral: If you default on your HELOC payments, you could be at risk of foreclosure and even lose your home.
• Easy to overspend: Since HELOCs give you access to large credit lines, it can be tempting to spend carelessly. Unfortunately, this could push you further into debt that you’re unable to pay back.
• You could owe more than you own: If your home’s value decreases, you could wind up owing more than your home is worth. 

Alternative options

Home equity loans and HELOCs aren’t the only options if you’re looking for funding. Alternatively, you might consider: 

• Personal loans: Personal loans aren’t secured by your home, making them less risky than home equity loans and HELOCs. Available in almost any amount, with many different loan terms and rates, these are great options for those who don’t own a home or aren’t willing to risk losing it.
• Credit cards: Credit cards have notoriously high interest rates — the average as of May 2023 is 20.68%, according to the Federal Reserve — but they could be a good choice for people who need access to funds quickly and who can pay them off each month. 

• Reverse mortgage: If you’re 62 or older, you can borrow against your home’s equity with a reverse mortgage. You’ll still live in your home, but you’ll need to repay your loan when you move out or sell your home. 
• Cash-out refinances: Cash-out refinancing involves replacing your current mortgage with a new one for a higher amount, then taking the difference in cash. This option often has lower interest rates than a home equity loan or HELOC, but may also come with higher closing costs.

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