Home Equity Loan vs. HELOC – What’s the Difference?

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With mortgage rates high and economic uncertainty looming, there is good news for borrowers who already have a mortgage and may be looking to tap into their equity.

According to Black Knight’s Mortgage Monitor report, the country’s home equity position remains strong compared to where it was at the start of the pandemic, with equity holdings at $5 trillion, or 46%, above pre-pandemic levels. The average mortgage holder is up more than $92,000 since the start of the pandemic.

Home equity loans and home equity lines of credit (HELOCs) are both loan products that are backed by the equity of a borrower’s home.

But what is the best option for your borrower? Read on to find out.

What is a Home Loan?

A home equity loan — also called a second mortgage, home installment loan, or equity loan — is a term loan based on a borrower’s home. Borrowers apply for a specified amount of money they need and receive that amount of money as a lump sum if approved. Home equity loans have a fixed interest rate and a set schedule of fixed payments for the life of the loan.

The equity in your borrower’s home serves as collateral for a home equity loan, so there must be enough equity in the home for the borrower to qualify. The loan size is based on several factors, including the combined loan-to-value ratio and whether the borrower has a good credit history. Typically, a home equity loan can be 80-90% of the property’s appraised value.

The interest rate on a home equity loan is fixed, as are the payments, meaning the interest rate does not change over time and the payments are the same over the life of the loan. The term of an equity loan can range from five to 30 years, and the borrower must make predictable monthly payments for the life of the loan.

Advantages and disadvantages

In terms of benefits, a home equity loan has a fixed amount — which reduces the likelihood of impulse spending — and a fixed monthly payment amount, making it easier for the borrower to budget for their payments. This type of loan can also be good for those who need a set amount of cash for something due to the principal payment.

The biggest potential downside to a home equity loan is that the borrower could lose their home if they can’t make their payments on time. In addition, draining all of their equity at once when real estate values ​​in their area are falling can work against them. Home equity loans also require refinancing to get a lower interest rate, and the borrower cannot borrow more money for an emergency without taking out another loan.

What is a HELOC?

A HELOC is a revolving line of credit that allows the borrower to borrow against the line of credit up to a preset limit, make payments on that line of credit, and then withdraw funds again. Rather than receiving the loan proceeds as a lump sum, a HELOC allows the borrower to draw on their line of credit when needed. This line of credit remains open until the end of its term. The loan amount can change, which means that the borrower’s minimum payments can also change depending on the utilization of the line of credit.

HELOCs are also backed by the equity of a borrower’s home. While it shares characteristics with a credit card in that it is a revolving line of credit, a HELOC is secured by this asset while credit cards are unsecured. HELOCs have a variable interest rate that can increase or decrease over time. This means that the minimum payment can increase as the installments increase. In addition, the interest rate depends on the borrower’s creditworthiness and the size of the loan.

The HELOC terms have two parts – a draw period and a redemption period. The withdrawal period is the time during which borrowers can withdraw funds. During this time, the borrower has to make payments, but these usually only include interest and are therefore usually small. When the drawing period ends and the borrower enters the repayment period, they can no longer borrow money and their payments now include the principal amount borrowed along with interest.

Advantages and disadvantages

HELOCs have some advantages. The borrower can choose how much or how little of their line of credit they want to use, and this line of credit is available for emergencies and other variable expenses. Variable interest rates mean that a borrower’s interest rate and payments could potentially decrease as their credit rating improves or market interest rates decrease. The borrower pays the interest, which is only accrued on the amount drawn by him, not on all the equity available in the HELOC. And HELOCs have a lower interest rate compared to other options for obtaining cash, like credit cards or personal loans.

However, since the HELOC is secured by the borrower’s home, they could default and lose their home if they don’t make their payments on time. It’s also more difficult to budget for fluctuating payment amounts, and it’s easy for the borrower to inadvertently spend beyond their credit limit. Variable interest rates mean that the interest rate and payments could potentially increase if a borrower’s creditworthiness deteriorates or market interest rates rise. And the transition from paying interest only to paying full principal and interest can be difficult for borrowers.

How to choose between a home equity loan and a HELOC

The best way to approach choosing between a home equity loan and a HELOC is to ask the borrower about the purpose of the loan.

If you know exactly how much you need to borrow and what you want to spend the money on, a home equity loan can be a good choice. Many borrowers use home equity loans for large expenses like a college fund, remodeling, or debt consolidation.

If the borrower is unsure of how much to borrow or when to use it, a HELOC may be a better choice. The borrower has continuous access to cash for a set period of time and can borrow against the line, repay some or all of it, and borrow that money again later provided they are still within the HELOC’s drawing period. HELOCs are also generally processed a little faster than a home loan if the borrower needs money quicker.

Keep up to date with the latest home equity news from HousingWire here.

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