For homeowners with established equity in their homes, a home equity line of credit can be a great way to leverage your investment. A home equity line of credit, also known as a HELOC, is a line of credit that homeowners can use for a variety of purposes, from consolidating higher-interest-rate debt, to financing home improvements, purchasing a second home, and a whole lot more. No matter the purpose for tapping into your home’s equity, you’ll first need to determine how much equity you currently have in your home.
What is equity in a home?
Equity is the difference between what you owe on your mortgage and what your home is currently worth. As you make mortgage payments, the money you pay goes toward interest on the loan, the principal amount you borrowed, or other fees and taxes. Money paid toward the principal becomes the equity in your home. Your equity can also increase if the value of your home rises. Equity can be built by making a large down payment and by paying more than the minimum mortgage payment. Another way to potentially build equity is to remodel your home, for example, by adding an extra room or enlarging the kitchen. Home improvements are a great way to add to your home's value.
Home Equity Loan vs. HELOC: What’s the difference?
If you’ve determined you have equity in your home, there are two different options to explore for loans—a home equity loan and a home equity line of credit. A home equity loan is a one-time loan using your home as collateral, also sometimes referred to as a second mortgage. With a home equity loan, you receive the money you are borrowing in a lump sum, and you usually have a fixed interest rate. The best lenders will offer a variety of repayment terms, low interest rates, and few fees.
In contrast, a home equity line of credit (HELOC) typically affords borrowers the ability to borrow or draw money multiple times from an available maximum amount over a period of time, called the “draw period.” Unlike a home equity loan, HELOCs usually have adjustable interest rates. HELOCs allow for flexibility around both borrowing and repaying money.
With a HELOC, you can borrow and repay for the length of your draw period, which potentially makes it the better choice if you plan to use the money over a longer period of time or for multiple purchases. With a single purchase, a home equity loan can be the better choice.
What is a HELOC used for?
HELOCs can be used in a variety of ways. These are some of the most common:
Pay off a Mortgage with a HELOC
Many homebuyers have built up equity in their homes but still have mortgage balances to pay off. A HELOC can reduce monthly payments and the overall interest paid on your loan. Since HELOCs sometimes have lower interest rates than mortgages, you could save money and potentially pay off your mortgage sooner. Even if the rates are similar, refinancing your first mortgage with a HELOC might still be a good option.
Large Purchases
A HELOC can be used for home renovations, cars, or even to purchase a second home. Keep in mind that the best use of a HELOC is usually one that improves your financial situation. This is why HELOCs are often used for home renovations. Home renovations typically increase the value of your home, which, in turn, will lead to a higher sale price when you eventually decide to sell. Even if you stay in your home for a long period of time after renovating, the renovations you funded with your HELOC can still increase your home value, creating more equity in your home that can be utilized in the future.
Consolidating Debt
HELOCs generally have low interest rates and can be a smarter way to consolidate higher-interest debt. In comparison to high-interest credit cards, a HELOC can offer a better option for debt repayments. Many HELOCs have variable, fluctuating rates, which can affect your monthly payments.
Emergencies
Having funds available when a crisis hits can make a huge difference on your ability to weather a storm. A home equity line of credit offers an option to pay emergency bills once all other means have been exhausted. A HELOC can afford homeowners peace of mind in an uncertain economic climate.
What to Look for in a HELOC
Interest Rates
A home equity line of credit rate can start low and increase over time, or it eventually becomes a variable HELOC rate. Rates will vary by lender, and even a small difference in percentage can lead to higher costs over time. Make sure that you understand and are comfortable with the rate over the lifetime of the line of credit.
Rate Caps
If and how interest rates are capped varies by lender, since HELOCs have variable rates. Some will operate based on minimum rates while others might have maximum rate caps. These details can have a significant impact on your HELOC over time.
Draw Period
Most HELOCs have a draw period designated in the contract. A draw period is the window of time the borrower has to withdraw funds. Some HELOCs may require a minimum draw before closing, and not utilizing this minimum can result in penalty fees.
Penalties
Confirm any penalties you may face before signing your loan contract. Prepayment or early closure penalties and balloon payments can be associated with HELOCs. A prepayment penalty is charged if all or part of the loan is paid back early. An early closure penalty is charged if the HELOC is paid off and closed within a certain period of time after opening. Balloon payments are large, one-time payments that occur at the end of your loan term, which can lead to lower payments early on due to the lump sum at the end. If you’d like to make consistent payments over time, ensure neither of these is included in your loan.
Minimums and Fees
Closing costs, annual fees, or cancellation fees may be included with your HELOC. It’s always important to understand and be comfortable with these before signing off on your loan.
Ready to get started with a HELOC or have more questions?
We offer two options for HELOCs that allow repayment flexibility: our Home Equity Interest-Only and Home Equity 360. Learn more here or speak to a loan specialist. Give us a call today to request a free consultation.
