If you’re a homeowner, you may have a valuable asset that you can leverage for immediate cash. Home equity loans and home equity lines of credit (HELOCs) allow you to tap into the equity in your home and use the funds for various purposes, such as home improvements, education expenses, debt consolidation, small business investments, emergencies, and more.
You may have a lot of home equity
With home values on the rise, many American homeowners are sitting on a significant amount of equity. According to a March 2023 report by CoreLogic, nationwide home equity increased by 7.3% ($1 trillion) in the fourth quarter of 2022 compared to the previous year. On average, U.S. homeowners gained nearly $14,000 in equity in 2022.
If you’ve seen your home’s value rise, you might be considering tapping into your equity. Two of the most common ways to do this are through home equity loans and HELOCs.
What is a home equity loan?
A home equity loan, also known as a second mortgage, allows you to borrow money using your home as collateral. The loan is provided by a mortgage lender, and you receive the funds as a lump sum. Typically, you can borrow up to 80% of the value of your home minus your primary mortgage balance. You can use the money for any purpose you choose.
A home equity loan usually comes with closing costs and a fixed interest rate, which is generally lower than other types of consumer loans and credit cards. Your payments are fixed, and you make them in addition to your regular mortgage payments. To qualify for a home equity loan, you’ll need to meet certain criteria, including a minimum credit score, a specific loan-to-value ratio, a debt-to-income ratio, a history of making payments on time, and proof of homeowners insurance.
What is a HELOC?
A HELOC allows you to access your home equity through a revolving line of credit. Like a home equity loan, a HELOC is provided by a mortgage lender, and your home serves as collateral. With a HELOC, you can draw money up to your credit limit as you need it during a designated draw period, typically around 10 years. During this time, you’re usually required to make interest-only payments on the borrowed amount. After the draw period, a repayment period begins, during which you’ll make regular payments to pay off the principal and interest.
A HELOC offers more flexibility than a home equity loan. It has lower interest rates than credit cards and may even come with a lower introductory rate. To qualify for a HELOC, you’ll need to meet similar criteria as for a home equity loan, including a minimum credit score, a loan-to-value ratio, a debt-to-income ratio, and proof of income.
When should you get a HELOC or home equity loan?
Both home equity loans and HELOCs can be used for various purposes, and there are typically no restrictions on how you can use the funds. They are ideal for large projects and expenses that require a substantial financial outlay. Some common uses for home equity financing include home repairs and improvements, high-interest debt consolidation, tuition payments, and major purchases.
It’s important to use home equity financing responsibly and have a plan in place to repay the loan or HELOC. The lender doesn’t dictate how you use the funds, but it does expect repayment. Failure to make payments could result in the loss of your home.
How do you get a HELOC or home equity loan?
The process of applying for a home equity loan or HELOC is similar to applying for a primary mortgage. Contact your mortgage lender to initiate the application process. You’ll need to provide documentation to prove your ability to repay the loan, such as bank statements and pay stubs. The lender will also check your credit score and credit history. An independent appraisal of your property will be arranged to determine its value accurately. Once approved, the lender will explain how you’ll receive the funds and the repayment terms, which may include closing costs.
Home equity loan and HELOC pros and cons
Home equity loans and HELOCs offer a way to access funds based on your home’s equity. However, it’s essential to understand the pros and cons of these financing options.
Pros:
- Relatively easy to obtain if you meet the qualification criteria
- Provide access to a significant amount of cash
- Lower interest rates compared to credit cards
Cons:
- Use your home as collateral, putting it at risk if you can’t make the repayments
- Multiple mortgage payments to manage, in addition to your regular mortgage
- If you sell your house, you’ll need to pay off both the primary mortgage and the home equity loan or HELOC balance
How to calculate your home equity
Calculating your home equity is simple. Subtract your mortgage balance from your home’s current value to determine the equity. To estimate your home’s current value, you can visit a website like Zillow.com and enter your address. Keep in mind that lenders generally require an independent appraisal if you apply for a home equity loan or HELOC.
Home equity financing example
Let’s say you want to build an addition to your home, and a contractor provides an estimate of $50,000 for the project. After discussing your options with your mortgage lender, you decide to apply for a home equity loan. Your home appraises at $400,000, and your mortgage balance is $175,000, resulting in $225,000 in home equity. Assuming the lender allows you to borrow up to 80% of your equity, you qualify for a $50,000 loan.
With a fixed interest rate of 7.0% and a repayment period of 10 years, your monthly payment would be $580.54, and the total repayment amount would be $69,664.80. The lender transfers the $50,000 to your bank account, enabling you to hire the contractor and begin your home improvement project.
Frequently asked questions (FAQs)
Does a home equity loan require an appraisal?
Yes, most lenders will arrange for an independent appraisal to determine your home’s value when applying for a home equity loan or HELOC.
How have the Federal Reserve’s recent rate increases affected home equity financing?
As the Federal Reserve raises the federal funds rate, which impacts the prime rate, the interest rates for home equity loans and HELOCs may also increase.
Can you have both a HELOC and a home equity loan?
Yes, it’s possible to have both a HELOC and a home equity loan simultaneously, as long as you meet the lender’s qualification criteria for each.
Are rates lower on a HELOC or home equity loan?
Typically, HELOCs offer lower interest rates compared to home equity loans.
How can I use the money from a home equity loan or HELOC?
You can use the funds from a home equity loan or HELOC for any purpose you see fit. Popular uses include home improvements, debt consolidation, and paying for higher education or emergency expenses.
Remember, it’s crucial to consult with a financial advisor or mortgage professional to fully understand your options and determine the best course of action for your specific situation.