If you find yourself in need of extra cash for a major purchase or personal expenses, you’ll likely start exploring loan options. Credit cards, personal loans, and home equity loans or lines of credit are some of the options available. Each loan type has its pros and cons, so it’s crucial to understand which loan works best for your situation.
In this article, we will delve into two popular secured loan options: a home equity loan and a home equity line of credit (HELOC), along with the requirements to obtain them. These loans are often the top choice for those looking to borrow a larger amount of money with a reasonable interest rate.
What are HELOCs and Home Equity Loans?
Both HELOCs and home equity loans utilize your home’s equity as collateral for the loan. Your home equity is calculated by subtracting your mortgage balance from the appraised value of your home. These loans come with lower interest rates compared to other credit products because your home acts as security.
While both HELOCs and home equity loans are secured by your home’s equity, there are some differences to consider. The main difference lies in how you repay the loan and how the interest factors into your repayment.
HELOCs and home equity loans are great options for funding large purchases, home improvement projects, education expenses, and even additional real estate investments. Additionally, many borrowers use these loans to consolidate high-interest debt due to their lower interest rates.
Home Equity Lines of Credit (HELOCs)
A home equity line of credit works similarly to a credit card, utilizing your home’s equity as security. With a HELOC, you’ll have a line of credit with a variable interest rate and repayment schedule, unlike a fixed-rate mortgage.
Similar to a credit card, you’ll only make payments and owe interest on the outstanding balance. For example, if you have a $75,000 home equity line of credit but only have a $5,000 balance, your monthly payment will be based on the $5,000 balance, including any interest.
During the draw period, which typically lasts 10-20 years, you can access funds from your HELOC as needed. You’ll make interest-only payments during this period. Once the draw period ends, you’ll enter a repayment phase where you must begin making principal and interest payments until the loan is fully repaid.
It’s important to be aware that most lenders have an introductory rate during the draw period, which may change after it expires. Before proceeding, ensure that you understand all the terms related to your HELOC.
Home Equity Loans
A home equity loan is more like an installment loan than a credit card or line of credit. With a home equity loan, you’ll receive the full loan amount upfront and make fixed monthly payments towards the principal balance over a set period. The interest rate is also fixed at the beginning of the loan.
There are limits on how much you can borrow with a home equity loan. The loan amount will depend on the equity you have in your home and your creditworthiness as a borrower.
How to Qualify for a Home Equity Loan or HELOC
To qualify for a home equity loan or HELOC, lenders will assess your financial profile. The main requirement is to be a homeowner, but lenders also consider other qualifications during the underwriting process.
Here’s what you need to qualify:
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Own a home: You must own a home with sufficient equity to qualify for either of these loans. If your mortgage balance is close to the appraised value of your home, lenders may not approve a loan due to the low amount involved.
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Be a creditworthy borrower: Despite your home’s equity serving as security, lenders still consider your credit profile. Late payments and accounts in collections can indicate poor debt management, making it challenging to secure a loan. A good credit score and a favorable debt-to-income ratio are important.
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Have enough steady income: Lenders ensure that you have a reliable source of income to cover existing and new debt obligations. Insufficient income may result in loan denial, even if your home has sufficient equity.
How Much Can You Borrow?
The loan amount you can receive based on your home’s equity depends on factors such as the appraised value of your home, your loan-to-value (LTV) ratio, the balance on your mortgage, your credit score, and debt-to-income ratio.
Before applying for a home equity loan or line of credit, determine your current LTV limit. This is calculated by dividing your loan balance by the appraised value of your home. Most lenders prefer a combined loan-to-value (CLTV) of 80% or less.
Different lenders may have minimum or maximum loan amounts, so it’s crucial to compare rates and loan estimates to find the best terms for your financial circumstances.
Alternatives to Home Equity Loans and Lines of Credit
If you don’t qualify for home equity loans or simply prefer other options, there are alternative loans to consider:
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Personal loans: These are unsecured loans that allow you to borrow a lump sum at a fixed interest rate. Personal loans can be used for large purchases, home improvements, medical bills, or debt consolidation.
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Personal lines of credit: Combining aspects of personal loans and credit cards, a personal line of credit is unsecured with a credit limit. You only owe interest and make payments on the outstanding balance. This type of loan requires a good credit profile and consistent income.
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Zero percent intro APR credit cards: If you have good to excellent credit, a 0% APR credit card promotional offer can be appealing. These cards allow you to carry a balance without paying interest for a specific period. They are useful for consolidating smaller amounts of high-interest debt.
At the End of the Day
Borrowing money can be overwhelming, but with research and comparison shopping, you can find a loan that suits your needs. Whether you opt for a home equity loan, credit card, or personal loan, carefully weigh the pros and cons of each option to make the best decision possible.
Remember, financial decisions are personal, and what works for one person may not work for another. Take the time to understand your options and choose wisely.
For more information and guidance on personal finances, visit Personal Finances Blog.