One of the advantages to owning a home is that you can tap into its value to accomplish — and afford — some of your goals.
As you make payments on your mortgage, you build equity (or ownership) in your home. That equity is the value that you can then borrow against.
When you borrow against your home’s value, you are getting a home equity line of credit or a home equity loan. While both products are loans against the equity in your home, they actually operate differently.
Borrowing against your home
No matter what type of loan you get, it’s important to understand that you are taking on new debt. This new loan is often called a second mortgage. It’s the second loan against your home’s value.
How much you are approved for depends on the lender. Many lenders prefer that you still have a loan-to-value (LTV) ratio of 80 percent or lower after the loan, according to Bankrate. So you need quite a bit of equity built up to get approved.
On top of that, your total debt-to-income ratio should be no more than 45 percent with your loan. You might find lenders willing to fudge the numbers a bit, but many lenders will stick with the requirements set out by Fannie Mae and Freddie Mac.
Finally, it’s worth noting that in some cases the interest you pay on a home equity line of credit or home equity loan is tax deductible.
How to calculate your home’s equity
In many cases, your equity is based on your LTV. Figuring it is fairly straightforward. You divide your current loan balance by the home’s current appraised value.
Let’s say your loan balance is $145,000. However, your home is appraised at $205,000. You divide $145,000 by $205,000 to get 0.7073. Round that number to get 0.71 and that’s your LTV. You end up with just over 70 percent LTV (or 30 percent equity in your home).
You can also express your equity in dollar amounts. In this case, you subtract the difference between your home’s value and what you owe to come up with $60,000.
However, your lender might not want to lend you enough to get you to that 100 percent LTV. Instead, you will be able to borrow up to 80 percent LTV. In this case, that means you can’t owe more than $164,000 on the home (80 percent of $205,000).
When you subtract the $145,000 that you already have from $164,000, you end up with the ability to borrow $19,000.
Home equity line of credit (HELOC)
What if you had a credit card guaranteed by the equity you build up in your home? That’s pretty much what a home equity line of credit is.
A HELOC loan is a rotating debt. You are given an upper limit to use and can draw on the line of credit as needed, making minimum payments. As you make payments on your HELOC, you free up that money for further use.
The interest rate on a HELOC loan is variable, based on the prime rate.
However, you need to be aware of the “draw” period, according to the Consumer Financial Protection Bureau (CFPB). Unlike a credit card, you can’t just keep using your home equity line of credit indefinitely. There is a time limit on it.
Once that time is up, you need to start paying in earnest. The CFPB points out that you might have to repay what you owe immediately. Or, depending on the plan, you might have a set period of time to pay it off in smaller chunks.
Either way, you need to make larger payments than the minimum to meet the repayment terms once the draw period ends.
Home equity loan (HEL)
Home equity loans, on the other hand, are installment loans. Rather than having access to the money as you want it, you receive it in one lump sum. If you discover you need more money, you have to apply for another loan.
Many home equity loans come with fixed rates and fixed payment terms, just like any installment loan. Unlike a HELOC loan, where you have to worry about rising interest rates, you always know what you will pay with a HEL.
Which is better? HELOC or HEL?
The best type of home equity financing depends on your specific situation and goals.
A HELOC loan can be a good choice if you are working on a project and you’re unsure of how much money you need. Home improvement projects can be ideal for a home equity line of credit. That way, you just take the money you need when you need it. And if you need a little more, you can get it without applying for another loan.
On the other hand, home equity loans often work well when you have a fixed expense. My parents actually used a home equity loan to help pay for my sister’s wedding and my wedding. If you know what you will pay for something, a HEL can be a good choice. You get the money once, use it, and repay the loan over time.
Downsides to HELOCs and HELs
One of the biggest downsides to these types of loans is the fact that you are taking on more debt. As a result, you run the risk of destroying your credit if you can’t make payment.
You could lose your house over home equity loans — but that is unlikely. Because your first mortgage has first claim, a home equity lender would have to pay off your original loan before foreclosing.
However, Investopedia reports that a lender could still sue you, garnish your wages, levy your bank accounts, or even go after other property you might own. It’s important to understand this reality before you take that step. You don’t want to borrow more than you can afford.
Another thing to watch out for is using home equity loans to pay off credit card debt. It might seem tempting, but now you’re taking unsecured debt and securing it with your home. Think very carefully before moving forward with something like this.
Choose your home equity loans carefully
A home equity line of credit or home equity loan can provide you with a way to meet some of your goals. Each type of loan has its benefits and can work for different situations. However, you need to carefully consider your options and think through the consequences before you sign your name to a contract.
To learn more about when to use equity and when not to, check out why using home equity to pay off your student loans is always a bad idea.