As a homeowner, your home is one of your most prized assets. With each mortgage payment, you gradually build up the equity in your property. This — your home equity — is the percentage of your home’s value that you officially own. Building home equity is a great way to increase your net worth. But you can also use your home equity as financial leverage to take out new credit.
There are two main types of credit you can get using your home’s equity: home equity loans and home equity lines of credit (HELOCs). Here’s how to choose the right option for your goals.
What is a home equity loan?
A home equity loan is a type of second mortgage that allows you to borrow against the equity you’ve built up in your property. Home equity loans are popular for debt consolidation as well as covering home repairs and remodels. If you qualify for a home equity loan, the bank will loan you a lump sum of money, which you’ll then repay via a series of fixed monthly payments over a predetermined period of time.
How does a home equity loan work?
Here’s how to take out, use, and pay back a home equity loan.
Check your eligibility: To qualify for a home equity loan, you’ll need to have a significant amount of equity in your property, as well as a good credit score and a stable income. To determine your equity, lenders typically look at your loan-to-value ratio (LTV). This number, expressed as a percentage, is the remaining balance of your mortgage loan divided by the cost of your house. So, if your house is valued at $300,000 and you have $250,000 left on your mortgage, your LTV is $250,000 / $300,000, or 83%. Lenders typically require an LTV of around 80% or lower.
Get prequalified: Before starting the official loan application process, you can opt for prequalification. This step involves providing basic financial information to the lender to get an estimate of the loan amount and terms you may qualify for.
Fill out a loan application: If you think you qualify, you’ll fill out an application with the lender of your choice. You’ll need to provide proof of income, property details, and your credit history.
Receive a property appraisal: Before approving your application, the new lender will conduct a property appraisal to determine the market value of your home. The maximum amount of money they’ll lend you is generally up to 80% of the equity you hold.
Agree on repayment terms: If approved, you’ll receive the approved loan amount in a single lump sum. (Once you take out the loan, your home equity will drop by an equivalent amount.) You’ll pay interest on your loan amount with each monthly payment. Most home equity loans have fixed interest rates, which means your monthly payment will remain the same throughout the life of the loan. The rate you qualify for will be based on your credit score, loan amount, and current loan-to-value ratio.
Use the funds: Unlike other types of loans, like home loans or auto loans, home equity loans can be used for almost any purpose.
Pay back the loan: Once you take out the loan, you’ll make monthly loan payments until the entire loan balance is paid off. When the loan is paid off fully, the amount of equity you own in your home will return to its previous level.
Pros and cons of a home equity loan
Pros of home equity loans
Fixed interest rate: Home equity loans tend to have fixed interest rates, which means stable, consistent monthly payments. These rates tend to be lower compared to rates on other types of credit, such as personal loans or credit cards.
Lump sum payment: Borrowers receive all the funds upfront in a single lump sum, which can be useful for large, one-time expenses.
Tax deductions: While the rules for tax deductions on home equity loans changed with the Tax Cuts and Jobs Act, you may still be able to claim a deduction on the interest you pay. Check with a tax professional.
Longer repayment terms: Home equity loans often come with long repayment terms, ranging from five to 30 years. A long term can mean more manageable monthly payments.
No restrictions on use: You can use the funds for a wide range of purposes, from home improvement projects to emergency expenses.
Cons of home equity loans
Risk of foreclosure: When you take out a home equity loan, you use your home as collateral. That means that if you default on the loan, you risk losing your property through foreclosure.
Multiple mortgages: Taking out a home equity loan adds to your existing debt burden. You’ll end up having to pay for that loan on top of your first mortgage. If you also have student loans or credit card debt, adding a home equity loan could make your debt difficult to manage.
Closing costs: Your home equity loan may come with closing costs, including application fees, origination fees, appraisal fees, or title search fees.
Negative equity: When you take out a home equity loan, the equity you own in your property decreases. If the market value of your home goes down after this point, you may end up owing more on your home than it’s worth. This negative equity can make it challenging if you need to sell or refinance in the future.
What is a home equity line of credit (HELOC)?
A home equity line of credit (HELOC) is a more flexible borrowing option for homeowners. Unlike a home equity loan, where you receive a lump sum upfront, a HELOC provides a revolving line of credit that you can draw from as needed, similar to a credit card. Your credit limit will be based on your home equity, your creditworthiness, and other factors.
How does a HELOC work?
Similar to a home equity loan, a HELOC allows you to borrow against the equity in your home. However, there are a few significant differences. Here’s how a HELOC works.
Determine your eligibility: As with a home equity loan, you’ll need to have a good credit score and a stable income to qualify for a HELOC. Lenders typically look for a loan-to-value ratio (LTV) of 85% or lower.
Get a property appraisal: After you fill out an application, the lender will conduct a property appraisal. Once again, your maximum credit limit will be a percentage of the home’s appraised value, which can typically be up to 80-85% of the equity you hold.
Use the funds: Once your line of credit is open, you can access funding as needed up to your approved credit limit. Most HELOCs let you make withdrawals within an initial “draw period,” which usually lasts 5 to 10 years. During this period of time, you only have to pay interest on the funds you take out — you don’t have to pay back the funds themselves until the draw period ends.
Pay back the principal: After the draw period ends, the repayment period begins. During this period of time, which usually lasts 10 to 20 years, you must pay back the principal along with any interest. Most HELOCs have variable interest rates. Once you enter the repayment period, you can no longer withdraw funds.
Pros and cons of a home equity line of credit
Pros of HELOCs
Flexible borrowing: A HELOC provides a revolving line of credit. This means you can take out funds as needed — up to the approved credit limit — without having to apply for a new loan each time.
Lower interest rates: HELOCs tend to have lower interest rates compared to other forms of credit, such as credit cards or personal loans.
Various repayment options: During the draw period, you have the option to make interest-only payments, which put less of a strain on your budget.
Minimal upfront costs: Unlike home equity loans, HELOCs often have few upfront costs or application fees, making them a more affordable option for homeowners.
Continue building equity: With a HELOC, you can continue building equity in your property as you make your mortgage payments. You’re less likely to end up with negative equity.
Cons of HELOCs
Variable interest rates: HELOCs typically come with variable interest rates. That means your monthly payment could increase over time.
Limited credit: The amount of credit available through a HELOC is contingent on your available equity. If the property’s value declines, or if your financial situation changes, your credit limit could decrease accordingly.
Risk of property foreclosure: As with a home equity loan, a HELOC relies on your home as collateral. Failure to repay the borrowed amount could result in foreclosure.
Which is right for me, a HELOC or a home equity loan?
Your perfect loan choice will come down to your specific financial needs, preferences, and circumstances. Here are some guidelines to consider.
Choose a home equity loan if:
You prefer predictable payments.
You need to cover a large, one-time expense.
You want to lock in a low interest rate.
Choose a HELOC if:
You need flexibility.
You’re comfortable with potential interest rate fluctuations and want to take advantage of lower rates during the draw period.
You’re uncertain about your exact funding needs.
You have an airtight plan to pay back the funds during the repayment period.
Alternatives to HELOCs and home equity loans
If you decide that neither a home equity loan nor a home equity line of credit is right for you, consider these alternatives.
Personal loans: Unsecured personal loans1 are available from banks, credit unions, and online lenders. While they don’t require collateral and can be used for various purposes, the interest rates on personal loans may be higher than what you’d get on a home equity loan.
Cash-out refinance: A cash-out refinance involves refinancing your existing mortgage for a higher amount and receiving the difference as cash. This can be a good option if you have significant equity in your home and your current mortgage rate is low.
Credit cards: For smaller expenses, a credit card with a low interest rate or an 0% introductory annual percentage rate (APR) may be suitable. It’s important to pay off balances quickly, however, as high interest rates can lead to expensive credit card debt.
Personal lines of credit: Personal lines of credit are another flexible borrowing option. These credit lines often have higher interest rates than HELOCs, but they don’t require home equity as collateral.
Home improvement loans: Some lenders offer loans designed specifically for home improvement or home renovation projects. These loans tend to have fixed interest rates, making them more predictable and budget-friendly.
Peer-to-peer lending: P2P lending platforms connect borrowers with individual investors willing to fund loans. Terms and rates vary based on your creditworthiness and each investor’s risk tolerance.
Compare loans on Navient Marketplace
If you’re looking for a personal loan to cover your upcoming expenses, consider using Navient Marketplace to get started. Navient partners with Fiona, a leading personal loan search tool, to help borrowers find loans custom-tailored to their needs. Go to Navient Marketplace today to find and prequalify for flexible loans from the country’s top lenders.
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