by BLACK ENTERPRISE Editors
The most common types of home equity loans are fixed-rate home equity loans, home equity lines of credit (HELOCs), and cash-out refinancing.
How does a home equity loan work? First, it’s important to understand that the term home equity loan is simply a catchall for the different ways the equity in your home can be used to access cash. The most common types of home equity loans are fixed-rate home equity loans, home equity lines of credit (HELOCs), and cash-out refinancing. The best type of home equity loan option for you will depend on your specific needs, so it’s helpful to know the characteristics of each to do an informed home equity loan comparison. SoFi breaks it all down.
Key Points
Home equity loans allow homeowners to borrow against the equity in their homes.
There are three main types of home equity loan options: traditional home equity loans, home equity lines of credit (HELOCs), and cash-out refinances.
Traditional home equity loans provide a lump sum of money with a fixed interest rate and fixed monthly payments.
HELOCs function like a credit card, allowing homeowners to borrow and repay funds as needed up to a specified limit within a set time frame.
Home equity loans and HELOCs can be used for various purposes, such as home renovations, debt consolidation, or major expenses.
What Are the Main Types of Home Equity Financing?
When folks think of home equity loans, they typically think of either a fixed-rate home equity loan or a home equity line of credit (HELOC). There is a third way to use home equity to access cash, and that’s through a cash-out refinance.
With fixed-rate home equity loans or HELOCs, the primary benefit is that the borrower may qualify for a better interest rate using their home as collateral than by using an unsecured loan—one that is not backed by collateral. Some people with high-interest credit card debt may choose to use a lower-rate home equity loan to pay off those credit card balances, for instance.
This does not come without risks, of course. Borrowing against a home could leave it vulnerable to foreclosure if the borrower is unable to pay back the loan. A personal loan may be a better fit if the borrower doesn’t want to put their home up as collateral.
How much a homeowner can borrow is typically based on the combined loan-to-value ratio (CLTV ratio) of the first mortgage plus the home equity loan. For many lenders, this figure cannot exceed 85% CLTV. To calculate the CLTV, divide the combined value of the two loans by the appraised value of the home. In addition, utilizing a home equity loan calculator can help you understand how much you might be able to borrow using a home equity loan. It’s similar to the home affordability calculator you may have used during the homebuying process.
Of course, qualifying for a home equity loan or HELOC is typically contingent on several factors, such as the credit score and financial standing of the borrower.
Fixed-Rate Home Equity Loan
With a fixed-rate home equity loan, the amount of closing costs is usually similar to the costs of closing on a home mortgage. When shopping around for rates, ask about the lender’s closing costs and all other third-party costs (such as the cost of the appraisal if that will be passed on to you). These costs vary from bank to bank.
Home Equity Line of Credit (HELOC)
HELOCs have two periods of time that borrowers need to be aware of: the draw period and the repayment period.
The draw period is the amount of time the borrower is allowed to use, or draw, funds against the line of credit, commonly 10 years. After this amount of time, the borrower can no longer draw against the funds available.
The repayment period is the amount of time the borrower has to repay the balance in full. The repayment period lasts for a certain number of years after the draw period ends.
A HELOC may be best for people who want the flexibility to pay as they go. For an ongoing project that will need the money portioned out over longer periods of time, a HELOC might be the best option. While home improvement projects might be the most common reason for considering a HELOC, other uses might be for wedding costs or business startup costs.
How Interest Rates Work on a HELOC
Unlike the rate on a fixed-rate loan, a HELOC’s interest rate is variable and will fluctuate with market rates, which means that rates could increase throughout the duration of the credit line. The monthly payments will vary because they’re dependent on the amount borrowed and the current interest rate.
When you take out a HELOC, you’ll start out in the draw period. Once you take out funds, you’ll be charged interest on what you’ve withdrawn. With some HELOCs, during the draw period, you’re only required to pay that interest; others charge you for both interest and principal on what you’ve withdrawn. During the repayment period, you won’t be able to withdraw money any longer, but you will need to make regular payments to repay the principal and interest on what you withdrew.
Home Equity Loan and HELOC Fees
Home equity loans and HELOCs both come with closing costs and fees, which may be anywhere from 1% to 5% of the loan amount. What those fees are and how you pay them, however, can vary by loan type. HELOCs may involve fewer closing costs than home equity loans, but often come with other ongoing costs, like an annual fee, transaction fees, and inactivity fees, as well as others that don’t pertain to home equity loans.
Generally, under federal law, fees should be disclosed by the lender. However, there are some fees that are not required to be disclosed. Borrowers certainly have the right to ask what those undisclosed fees are, though.
Fees that require disclosure include application fees, points, annual account fees, and transaction fees, to name a few. Lenders are not required to disclose fees for things like photocopying related to the loan, returned check or stop payment fees, and others. The Consumer Finance Protection Bureau provides a loan estimate explainer that will help you compare different estimates and their fees.
Home Equity Loan and HELOC Tax Deductibility
Cash-Out Refinance
Mortgage refinancing is the process of paying off an existing mortgage loan with a new loan from either the current lender or a new lender. Common reasons for refinancing a mortgage include securing a lower interest rate, or either increasing or decreasing the term of the mortgage. Depending on the new loan’s interest rate and term, the borrower may be able to save money in the long term. Increasing the term of the loan may not save money on interest, even if the borrower receives a lower interest rate, but it could lower the monthly payments.
As with home equity loans, there typically are some costs associated with a cash-out refinance. Generally, a refinance will have higher closing costs than a home equity loan.
This loan type may be best for people who would prefer to have one consolidated loan and who need a large lump sum. But before pursuing a cash-out refi, you’ll want to look at whether interest rates will work in your favor. If refinancing will result in a significantly higher interest rate than the one you have on your current loan, consider a home equity loan or HELOC instead.
When to Consider a Cash-Out Refinance
Pros and Cons of Cash-Out Refinancing
Cash-out refinances involve both advantages and drawbacks. Here are some of the most significant.
Pros:
Allow you to access a lump sum of cash
Can potentially give you a lower mortgage rate
May let you change your mortgage terms to adjust your payments
Cons:
Uses your home as collateral
Adds another debt in addition to your mortgage
Requires you to pay closing costs
Comparing Home Equity Financing Options
The different types of home equity loans all allow you to draw on the equity you’ve built in your home to access funds. But each type has different strengths and weaknesses, and the best type of home equity loan option for you will depend on your situation and the characteristics of the loan.
Which Type Is Right for You?
If you’re content with your mortgage — you don’t think you could get a better rate and your payments fit your budget — and you need a lump sum all at once, a home equity loan might make the most sense. To consolidate high-interest debt, buy a boat, or take a once-in-a-lifetime vacation, this might be a good option.
If your mortgage is fine and you need funds for a project that’s going to require withdrawals over time, a HELOC might be a good fit. Say you’re financing your child’s college education or starting a new business – having a line of credit to draw on when you need it could be extremely helpful.
Finally, if you’re looking for a lump sum and you feel that your mortgage isn’t a good fit, a cash-out refinance could be for you. Perhaps you could get a lower interest rate now, or you’d like your term to be shorter and can afford the higher payments. In that case, a cash-out refinance could be useful.
Factors to Consider Before Choosing
As you do your home equity loan comparison and think about your options, it’s important to consider carefully what will really work best for you. Here are some questions to review.
Will you be able to handle the additional debt in your budget?
Do you need an upfront cash sum or access to funds over time?
Can you realistically improve significantly on your current mortgage terms?
Is what you stand to gain worth more than the price of your closing costs and any other fees involved?
Are you OK with payments that vary, or would you prefer knowing that your payments will stay the same?
Are you comfortable knowing that your lender may be able to foreclose on your home if you can’t make your payments?
The Takeaway
There are three main types of home equity loans: a fixed-rate home equity loan, a home equity line of credit (HELOC), and a cash-out refinance. Just as with a first mortgage, the process will involve a bank or other creditor lending money to the borrower, using real property as collateral, and requiring a review of the borrower’s financial situation. Keep in mind that cash-out refinancing is effectively getting a new mortgage, whereas a fixed-rate home equity loan and a HELOC involve another loan, which is why they’re referred to as “second mortgages.”
While each can allow you to tap your home’s equity, what’s unique about a HELOC is that it offers the flexibility to draw only what you need and to pay as you go. This can make it well-suited to those who need money over a longer period of time, such as for an ongoing home improvement project.
FAQ
What is the downside of a home equity loan?
The primary downside of a home equity loan is that the collateral for the loan is your home, so if you found yourself in financial trouble and couldn’t make your home equity loan payment, you risk foreclosure. A second consideration is that a home equity loan provides you with a lump sum. If you are unsure about how much you need to borrow, consider a home equity line of credit (HELOC) instead.
Can you use a home equity loan for anything?
Typically, you can use a home equity loan for just about anything you want to. Common reasons for taking out a home equity loan are to consolidate higher-interest debt, to pay for medical bills, and to fund major home repairs or upgrades. It’s important to remember that your house serves as collateral for the loan, so you want to be sure your use is worth the risk.
How do I qualify for a home equity loan?
What is the difference between a HELOC and a cash-out refinance?
This story was produced by SoFi and reviewed and distributed by Stacker.
RELATED CONTENT: The Hidden Home Equity Tax Straining Families For Staying In House Too Long
Source: Black Enterprise
