Whether for home improvement, reaching a financial goal, or an emergency, cashing in on your home’s appraised value is an attractive proposition. Depending on how much equity is built, every owner with financial needs can explore several options to raise some cash without having to sell. Two common options to leverage on home equity are its equity loans and equity lines of credit.
Both mortgage products help homeowners to achieve the same end: borrow money with the current value of their home. But they are different. The best financial decision to make, between the two, depends on several factors. Most of these factors, which determine the rate and other terms of the loans, are based on personal circumstances like the purpose, income, and ability to repay.
Understanding both mortgage products helps you decide the best one to extract value from your home for your financial needs or project. Before delving into the pros and cons, first is an insight into home equity and how much you can borrow against it.
Understanding and Calculating Your Home Equity
Home equity is the difference between the market value of a property and the amount registered against the property. In other words, it is the amount left if you sell your house and deduct all the debts owed on it. Any down payment you make on a home increases your equity because this value equals the portion of the property’s value that belongs to the owner.
When it comes to borrowing against your home equity, it is a thorough process that starts with the home appraisal. If you only need to borrow for everyday expenses or emergencies, search for the best cash advance app to access quick loans with collateral. These paycheck cash advance apps lend out money with no credit check.
Home equity lenders, however, require and also run an appraisal on your abode before issuing a loan. Appraisals are needed to protect the lender’s investment. On the flip side, it protects you from an inflated loan that may sink your finances. Generally, lenders require you to pay off 15 – 20% of your home value and may loan you up to 85% of your home equity. For instance, if you have a mortgage of $80,000 on a home valued at $200,000, your home equity will be 60% or $120,000.
Furthermore, lenders calculate home equity with a combined Loan to Value ratio. LVR is the amount owed on the home divided by its lender-assessed value. High ratios, especially over 80%, are considered too risky. For instance, borrowing $400,000 on a house appraised at $500,000, your LVR is 80%. You can either add to your home equity by paying to decrease your mortgage balance or increase the home’s market value.
The latter may be due to market conditions. In the case of minor yet urgent renovation and other expenses, you use money borrowing apps in the app store to source funds to get them done. It may also be due to adding values like renovations.
How Does a Home Equity Loan Work?
As the name implies, a home equity loan is a fund borrowed against a portion of your home’s equity. Though issued separately, the loan works like a conventional mortgage. If approved, the money is paid in a lump sum, and payment will be expected over a predetermined period. Typically, the loan has a fixed interest rate, making it easier to make provisions for it in the monthly budget.
This equity loan is often referred to as the second mortgage. Like the original home mortgage, you repay the principal and the interest accrued monthly all through the life of the loan. Homeowners with small financial needs, emergencies, or cash infusions prefer this option. But most importantly, it suits borrowers with a stable financial ability to make consistent, structured repayments.
And like the regular mortgage, you may have to pay loan processing, appraisal, recording, and origination fees. Since the home is the collateral, defaulting on repayment can lead to foreclosures.
Pros of Home Equity Loan
- Interest rates are fixed through a specified time
- There is the same monthly payment at low-interest rates
- Better chance of obtaining sum against home equity than other avenues
- Repayment may be over an extended period.
Cons of Home Equity Loan
- Rigid disbursement of a lump sum may lead to over-borrowing
- Expensive closing cost
- Risk of losing your residence to foreclosure or ending up underwater if market value dips
- Lack of option to renew or extend the loan
How Does a Home Equity Line of Credit Work?
Similar to Home Equity loans, HELOC lets the homeowners tap into the equity built up in their residential areas, as they serve as collateral. Once the loan application is approved, an account is created with a credit limit determined by the available equity. You can access funds from the account to a set limit during the draw period, just like a credit card. The amount that can be borrowed within the set period cannot exceed 85% of your home market value. Most financial institutions offering this loan make the fund easily accessible via check, online transfer, or credit card dedicated to your account.
The first part of the HELOC is the draw period, typically 10 years. During this period, you can draw from your credit line but make a monthly payment on the loan. Payments are only charged on the amount drawn and never on untapped funds. After 10 years of drawing comes the repayment period. During this period, funds can no longer be drawn against the credit line. Instead, you will repay the principal monthly over an extended period of 10 to 20 years.
- Only interest is paid during the drawn period
- Flexible loan disbursement with interests charged only on drawn fund
- Easier to maintain good payment history and boost credit score
- You borrow when needed
- Variable interest rates can increase
- Risk of foreclosure
- Risk of impulsive borrowing and overspending
- It takes time to pay off and limits additional opportunities
Which One Is Right for You?
Your financial need should take priority when deciding between a home equity loan and HELOC. HELOC seems more logical if you embark on a project requiring a periodic infusion of small cash instead of a large amount. A home equity loan is a better choice for a significant expense needed in a short time and can be repaid monthly. After deciding on the best borrowing option, shop around to get the best fees, interest rates, tax advantages, and monthly payments.