One of the main advantages of owning a property (be it a house or an apartment) is building equity over time, which can be leveraged to your financial benefit. When you have enough equity, you can apply for low-interest loan options that come in two different varieties: Home Equity Loans or Home Equity Line Of Credit (HELOC).
Most homebuyers that have a considerable amount of equity built up aren’t aware that they can make use of it towards financing their ventures, paying off builds, or putting it towards renovations that add even more to the home’s overall value.
But savvy individuals often prefer using their home equity as collateral to take out a loan for significant expenses like home renovation, or for emergencies like medical expenses to save on potential interest charges. If you are planning to borrow money using a home equity loan or HELOC, you must learn the basic differences between these two types of loans so that you can decide which is a better option for you.
What is an equity loan?
Both home equity loan and HELOC use the total equity of your property. The equity is calculated by subtracting the mortgage balance from the current value of your property. Home equity loans offer competitive interest rates. When compared with unsecured sources like credit card loans or personal loans, you will be paying fewer financing charges for the same loan amount for an equity loan.
Usually, the total amount of money you can borrow depends on the loan-to-value ratio (LTV). It is calculated by dividing the amount you are borrowing by the value of your property, with a limit of 80% of your equity. But you need to remember that the amount offered will depend on various factors like your payment history, credit score and annual income.
But there is a certain risk associated with using your property or your home as collateral. If you fail to make the payments, your home can be sold to recuperate the owed amounts. As such, it’s a good idea to ensure you’re financially secure before taking out one of these loans.
Home equity loans
A home equity loan is a secured loan backed by your property’s equity value. Usually, the homeowner gets a lump sum amount of cash. It is a popular choice among homeowners when they need money for significant one-time expenses like renovation, wedding, or medical expenses. In most cases, loans come with fixed interest rates and fixed repayment terms which vary between 5 years to 30 years, depending on your financial history.
Over the course of this loan, if you pay all the monthly payments in full amount and on time, your credit score might also improve over time. Therefore after a few regular monthly instalments, the lender might reduce the interest rate. Additionally, if you use the loan amount to increase the value of your home through the renovation, the interest might also be tax-deductible.
Advantages of home equity loans
- You can use the loan amount towards any financial ventures you’d like.
- These loans usually come with lower interest rates compared to other types of loans for consumer debt.
- If you put the amount for renovation to increase the value of your property, the interest might be tax-deductible.
Disadvantages of home equity loans
- By any chance, if the property value declines dramatically, you’ll see a drop in actual monetary gain.
- There are risks if the payment is not made, and you might end up losing your property entirely.
- Most of these loans have high home equity requirements, which are usually about 15 to 20% of the home’s value.
Home equity lines of credit (HELOC)
HELOC is a type of equity loan which is pretty similar to a credit card and operates as a line of credit. The homeowner is allowed to borrow up to a certain amount, and they can take out as much they need whenever they want.
But there is a specific time duration known as the draw period. During this duration of 5 to 10 years, you will only be paying the interest on the money that you are borrowing. At the end of this period, you have to start paying back the principal amount. Depending on your credit score and history, you will be offered a payment period of about 10 to 20 years.
This simply means that you will be paying less interest than you would have to pay if you had taken a traditional 30-year mortgage. However, the monthly payments will be higher. In most cases, HELOC comes with a one-time annual maintenance fee and the cancellation fee.
Most banks and financial institutions offer homeowners various methods to access these funds. Some of the common ones include online transfers, credit cards connected to your account or using a cheque. A significant advantage of HELOC is that you can borrow from the credit line anytime you want, but no interest is charged on the unused fund. So most people can opt for this loan during emergencies.
Advantages of HELOC
- In certain situations, the interest rate is tax-deductible
- You can borrow as much as you need from the funds at any time
- Banks and financial institutions providing HELOCs offer flexible repayment options
Disadvantages of HELOC
- As it is a long-term line of credit, you risk having a larger debt. Therefore spending has to be closely monitored.
- The variable interest rate can change over the course of time
- You also risk losing your home if you do not make the payments on time
Often, during a financial emergency, some immediate extra cash can be useful. This is when most homeowners prefer a second mortgage on their property. As the loan is secured against the equity value of your property, most money lenders and financial institutions offer lower interest rates compared to other types of loans.
Borrowing money from your home’s equity is a risky move. However, if you are dedicated and pay all the instalments and time, you won’t lose your property. Home equity loans are an ideal choice to get large amounts of money at low interest, and they can offer various long-term benefits.
So if you are still not sure whether you want to borrow from a home equity loan or a HELOC, you can always conduct a financial audit of your property to understand which loan is suitable for you. Additionally, you can also research the various benefits and charges before applying. Also, before applying for the loan, it is recommended that you compare the money lenders and then select the one willing to offer the most competitive rates.