As a homeowner, you might find yourself in situations that require a large sum of money, such as kitchen remodeling or large-scale garage repairs. Cash-out refinance, which involves trading your current mortgage for a new mortgage and receiving the difference in cash, might not seem like the best choice due to the risk of higher interest rates and reduced equity.
In such cases, you have two loan options based on your home equity (the percentage of a property that you actually own by deducting the outstanding mortgage from the total value). These are home equity loans and home equity lines of credit (HELOC).
Choosing between the loan options depends on your spending habits and, ultimately, the purpose of the loan. By understanding the similarities and differences of each loan type, you can select the most stress-free option while fulfilling your financial commitments.
Home equity loans are a type of installment usually repaid with fixed monthly payments over a fixed period of time. Most lenders usually offer loans of up to 85-90% of an individual’s home equity. Under home equity loans, you receive a lump sum of money upfront, which you can freely spend on your needs.
HELOC is a revolving line of credit that functions similarly to a credit card limit. You can calculate the HELOC amount you may qualify for based on your property’s fair market values, outstanding home loans, and loan-to-value ratio limits.
You do not need to spend the entirety of the line of credit approved by your lender and only incur interest for the borrowed amount. The HELOC loan comprises two time frames: the draw and repayment period.
You can repeatedly borrow from a HELOC as long as you repay the previously loaned sum within the draw period, which usually lasts between five to ten years.
Once the draw period expires, you can no longer borrow from the line of credit as it enters the repayment period that extends between 10-20 years. During this time, you are required to make fully amortized repayment of the outstanding loan balance, which includes the principal sum and interest.
HELOC and home equity loans are secured loans as they leverage home ownership stake or equity as collateral. Since secured loans provide lenders with collateral as added assurance, they often come with lower interest rates than unsecured personal loans.
By using the home as collateral, defaulting on loan repayment could result in property foreclosure. Both loans involve closing costs (often higher for home equity loans since they involve dispensing a lump sum of money), including loan application costs, attorney fees, and other miscellaneous charges.
Lenders of both loan types require a thorough assessment of a borrower’s credit score, equity, and debt-to-income ratio (lenders calculate this by dividing your fixed monthly debt over your monthly income). Similarly, lenders tend to provide a limit of 80-85% of a property’s appraised value while deducting the outstanding mortgage amount.
HELOC and home equity loans come with their own pros and cons, mainly in the cash out of the loaned funds and their repayment process.
HELOC works best for you if you seek spending flexibility according to shifting financial demands and investments. For example, homeowners may tap on a HELOC’s revolving line of credit for managing each project’s varied renovations and remodeling costs.
A HELOC loan may provide a lower introductory rate compared to a home equity loan and borrowers are usually only required to pay the incurred interest during the draw period. However, the variable interest rates of HELOC could prove financially challenging in the long term, especially during high-interest markets.
Home equity loans are most suited for you if you want to receive a fixed sum that you aim to pay off over an extended period of 15-20 years. Individuals who borrow home equity loans tend to have clarity of their borrowed spending, such as funding a home renovation or college education. With home equity loans, you can have peace of mind paying a fixed monthly amount without risking market-led interest fluctuations.
Deciding between a HELOC or home equity loan comes down to your financial health and spending needs. While there is no limit to the number of home equity-leveraged loans you can apply for, each application reduces your total amount of available equity for qualifying for a loan.
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