A home is one of the biggest investments many of us will ever make. One advantage of owning one is that it can create a great deal of financial security and become a bona-fide source of cash. Homeowners in need of a quick financial fix or keen to make another investment, for instance, may be eligible to tap the equity of their home to obtain money.
“Equity” refers to the appraised market value of a home, minus that which is owed on it. If a home is valued at $400,000, with $150,000 owed on it, the available equity would be $250,000.
Two mainstream financial vehicles enabling property owners to borrow against this accrued equity are a home-equity loan and a home equity line of credit or HELOC. While both draw funds against the equity value, they function quite differently and cater to different borrowing needs. The primary distinction between the two is how the funds are disbursed.
A home-equity loan (read Home-Equity Loans: The Costs), sometimes called a “term loan,” pays the borrowed money in one lump sum, just like a typical personal loan. A line of credit allows borrowers to withdraw funds (up to the approved credit limit) as required – much like a credit card. Both are also referred to as “second mortgages” because they are secured by your property, just like the original (primary) mortgage. However, unlike first mortgages (which generally run for 30 years), equity-financing options typically come with shorter repayment periods of anywhere from five to 15 years.
So which borrowing model fits best? It depends on a number of factors, such as the purpose for which the loan has been sought, fixed vs. variable interest rates, desired loan term, how much you intend to borrow and preferred repayment structure.
Since the loan funds are disbursed in a one-time lump sum, additional money cannot be withdrawn from the loan (as is the case with HELOCs). These loans set up regular monthly repayments over a set amount of time – the same way a primary mortgage is paid off in fixed installments. This financing model is ideal for borrowers who prefer the security offered by fixed-interest rates and for those requiring a substantial sum for another investment, such as a second home or car, or for debt consolidation.
Home Equity Line of Credit
HELOCs function like a revolving line of credit (see What are the differences between revolving credit and a line of credit?) that’s suited to individuals who need access to a reserve of cash over a period of time, rather than upfront. For example, homeowners often use a HELOC to fund renovations and home improvements, as contractors and materials can be paid for as required. This provides cash as needed and mean you’re never paying interest on more borrowed funds than you actually use at any one time.
A HELOC allows you to borrow up to a certain amount for the life of the loan, or “draw period,” set by the lender. During that time, you can withdraw cash as you need it; as you repay the principal, you can use the credit again. Credit lines have a variable interest rate that fluctuates over the loan’s lifespan, so payments will vary depending on the interest rate and how much credit has been used.
HELOCs generally offer more repayment flexibility than a Home Equity Loan. For instance, during the equity line’s draw period you can make either minimal monthly interest-only repayments or elect to pay the principal as well. Some lenders require borrowers to pay back the entire amount at the end of the draw period; others may allow you to make payments over an additional time period known as the "repayment period."
The beauty of home-equity loans and HELOCs is that interest rates are generally much lower than unsecured bank loans and credit cards, as the borrower’s property serves as collateral. Home-equity loans typically have fixed interest rates so repayments are made on the entire lump sum, while HELOCs are (generally) variable, so monthly repayments vary according to the market. Interest on both loan types can be tax deductible for loan amounts up to $100,000, but you need to consult your tax advisor to see whether you qualify.
The amount of equity in your home evolves with time, according to market conditions, outstanding mortgages (and how quickly you pay them off), capital growth and home improvements made to the property. The faster you pay down your mortgage, the more equity you will free up. And the faster you add value, the more equity you will create.
In order to get an accurate equity figure on which to base the loan or line of credit, a professional appraiser will be hired to value the property. The lending institution considering issuing the loan will provide its own appraiser to determine the home’s value/equity and borrowing potential after you have applied for the it.
The amount you qualify for is based on a number of factors that include the property’s loan-to-value ratio, the loan's payment term, and the usual borrowing criteria such as verifiable income, other debts and your credit history.
The Bottom Line
As housing prices rise across the country, home equity loans and HELOCs offer an appealing, low-interest way for homeowners to borrow against their bricks and mortar. They’re a logical financial avenue through which to fund everything from renovations to college fees and an investment property.
Since you're putting your home on the line, avoid using these funds for frivolous purposes or borrowing more than you can repay. Basic issues to consider are whether you really need the money, the purpose of the loan, how much you intend to borrow (and how much you can comfortably repay), ideal repayment structure and the going interest rates. Refer to your bank or lending institution’s online calculators to assist with numbers. And as with any finance product, be sure to shop around for the best deal.