Tapping Into the Equity of Your Home
When looking to utilize the equity that you have built in your home, there are two types of home equity loans available: term, also known as closed-end loans, and lines of credit. Because you are using your home as collateral (security) and because the loan is held subsequent to the original deed, both loans are often referred to as second mortgages and will appear on the title as such. While similar, these two types of low-interest funding have different advantages for financing projects with a large price tag or for providing an extra financial boost to meet some of your life goals. Today, we share some of the advantages of and the differences between a Home Equity Line of Credit (HELOC) and a Home Equity Loan (HE Loan) and some considerations for determining when this may be a good financing option for you.
What is a Home Equity Loan?
A home equity loan is a loan that you receive as a lump sum and once you receive the funds, you can not borrow any more from that home equity loan. Since you receive money in a lump sum, these loans are most suitable when you need cash all at once, or for a specific one-time event, such as paying for a wedding, financing major home renovations or getting rid of other obligations such as high interest rate credit-card debt.
The major benefit of a home equity loan is that it usually carries a fixed interest rate, making your monthly payments highly predictable and comprised of both principal and interest. This is important if you’re living on a fixed income or want to know precisely what your mortgage repayment will be for the life of the loan, allowing you to budget your monthly cash flow more accurately.
What is a Home Equity Line of Credit?
For simplicity, a Home Equity Line of Credit can be thought of as a secured credit card for your home; meaning that the “limit” correlates to the value of your home and that it is secured by your home. The major difference between a HELOC and an HE Loan is that, as previously stated, an HE Loan is a lump sum loan whereas a HELOC is similar to a credit card. With a HELOC, you have a certain amount of money available to borrow and pay back, but you can take what you need as you need it. Home equity lenders typically provide debit cards or checks to use for HELOC loan withdrawals, and also allow you to access the funds at your local branch. Furthermore, your monthly payment on a HELOC is a minimum interest only payment that will fluctuate depending on the total balance.
Unlike an HE Loan, a line of credit will typically have variable interest rates. It is also important to note that you will probably have a limited amount of time to use the funds as a majority of HELOCs have a defined draw period.
How Do You Calculate Your Equity?
To accurately calculate your equity, you must determine the loan-to-value (LTV) ratio. This is done by adding the amount of your first mortgage and the HELOC or HE Loan, and dividing that amount by the appraised value of your home. Based on most bank guidelines for a home equity loan or a HELOC, a lender typically won’t offer a loan that exceeds 80 percent of the home’s appraised value. However, some banks and credit unions may lend as much as 95 percent of the loan-to-value ratio, with an added margin to the loan interest rate.
Let’s review an example to more simply explain how to determine the maximum loan amount for a typical HE Loan or HELOC. Say, for example, that your home appraises for $500,000 and your outstanding mortgage balance is $235,000. This results in an equity amount of $265,000. Many borrowers make the mistake assuming that the total equity, in our example $265,000, is the maximum amount that they can borrow. However as previously mentioned, a lender won’t typically exceed 80 percent of the loan-to-value ratio, meaning that our example would result in a maximum loan amount of $165,000.
Home Equity Loan Formula:
Appraised Value * LTV Limit – Outstanding Balance ($500,000 * .80 – $235,000 = $165,000)
Which One is Best?
As with most financial planning questions, the answer to this question isn’t always black and white. However, there are times when the choice is obvious. For example, HE Loans are helpful for reaching more expensive goals, such as debt consolidation, home remodeling and paying for college. With their unchanging payments, they’re more manageable for fixed incomes.
However, if you need money over a staggered period of time, HELOCs are ideal for covering medical emergencies, smaller home improvement projects and paying bills that will escalate quickly if left unpaid. Furthermore, if you borrow relatively small amounts and pay back the principal quickly, a line of credit can cost less than a home equity loan. Nonetheless, they’re not meant to be a long-term loan or a financial cushion for more comfortable living habits. Although a HELOC gives you great flexibility and ease of access, those features can be detrimental for the wrong borrowers. If you use your HELOC as a piggy bank, before you know it, you’ve overextended yourself.
Another attractive feature of home equity financing is the ability to deduct the interest on your tax return. However, limitations and special rules apply and you must consult with your tax professional to determine the eligibility of your specific circumstance.
As with all financial decisions, you should frame the purpose and overall outcomes of your borrowing needs before deciding if either of these loans are the right option for you. As always, Yeske Buie is available to help you answer these questions or provide a recommendation based on your personal needs. Please do not hesitate to reach out to us!