Equity loans, lines of credits (HELOCs) – How They Work, Pros & Cons


If you need a loan and not sure which of them is a better fit for your needs – you are in the right place.

In this article – we would try to understand what is the difference between Equity loans and lines of credits (HELOCs), and what are the pros and cons of the different options.

Simply put, a home equity loan lets you borrow money against the value stored in your home.

They’re a useful option if you need to borrow a large amount of money.  It’s also easier for you to get an approval because your house acts as the security for the loan.

If your home value is greater than the current mortgage you owe on it, you can apply for a home equity loan.  You can use the loan for anything you like and not strictly for home-related expenses.

A home equity loan is in fact, a type of the second mortgage on your home.  The ‘first’ mortgage is the one you took to purchase your home.  Even if you still have an outstanding mortgage, you can borrow against your property if you have built enough equity.

What Is A ‘Home Equity Loan’

A home equity loan goes by many names such as equity loan, home-equity installment loan, or second mortgage.  Technically, it falls under the classification of consumer debt.  Homeowners can borrow against their equity in their homes in case they need additional funds.

Lenders look at the difference between the homeowner’s equity and the home’s current market value.  Though it’s a mortgage, it also provides collateral for an asset-backed security that the lender issues.  It allows the borrower to have tax-deductible interest payments too.

However, just like any mortgage, should the borrower default, the bank can sell the home to satisfy the outstanding debt.

Fixed Vs Adjustable Rate 

Equity loans can be fixed-rate or adjustable-rate loans and come with a set repayment time.  This is anywhere from 5 to 30 years.  Borrowers still have to pay the closing cost but it’s lesser than what is on a regular full mortgage. Some borrowers prefer the fixed-rate HELs because it provides the predictability of interest rates from the onset of the loan.

Home equity loans became extremely popular after the Tax Reform Act of 1986 because they gave consumers a way to circumvent one of its main provisions. We’re talking about a method to jump past the feature that eliminates deductions for the interest on many consumer purchases.

The one major exception, however, is interested in the service of residence-based debt.  This means that homeowners can borrow up to $100,000 in home equity loan and deduct all interests on it on their income tax.  This is applicable only if they make itemized deductions on their returns.

Example 

Let’s say you purchase a house with a price of $300,000.  You put up a down payment of $80,000 and take out a loan for the remaining $220,000.  On the day of purchase, your equity is equal to your down payment of $80,000.  You may see an equation like this:

$300,000 (home purchase price) –  $220,000 (amount financed) = $80,000 (equity)

Let’s say five years later, after you’ve faithfully paid monthly payments, you’ve paid off $75,000 of the mortgage.  This means you now owe only $145,000.  About this time, the value of your house has appreciated and is now worth $400,000.  Your equity is $255,000:

$400,000 (home’s current value) – $145,000 (amount owed) = $255,000 (equity)

Equity computation

House purchase price                                                             $300,000

Amount borrowed                                                                  ($220,000)

Down payment/equity                                                            $80,000

After 5 years

Loan balance                                                                           $180,000

Principal paid                                                                         ($35,000)

Amount owed                                                                         $145,000

House’s current value                                                           $400,000

Amount owed                                                                         ($145,000)

Equity                                                                                     $255,000

 

Equity loans (HELs) and lines of credits (HELOCs) – How They Work

There are two types of home equity debt: home equity loans (HELs) and home equity lines of credit (HELOCs).  They are also both called second mortgage because like the first or primary mortgage, you used your property as security.

HELs and HELOCs usually have a shorter repayment time than first mortgages.  Most mortgages are usually over 30 years.  Equity loans and lines of credit often have a repayment period of 15 years.  In some cases, they can be as short as 5 years and as long as 30 years.

A home equity loan usually requires a one-time lump sum paid off over a set amount of time with a fixed-interest rate.  This means that the borrower would make the same payments each month.  Once the lender releases the loan, the borrower cannot borrow further from the loan.

HELOC Is The More Flexible

The HELOC is the most flexible option because you pay interest only for the amount you actually draw down from your credit line.  HELOC interest rates are generally variable, so the interest rate can change (to your favor or against) over time.

However, the lender has the right to freeze or cancel your line of credit even before you’ve made a draw down.  This means that there may be a possibility that you may not get the chance to use the money – that is the risk that comes with flexibility.

To get a loan, you have to first apply with a lender.  So it is good to canvass the different sources so you can get the best option.  Interest rates will vary from place to place and there’s also the closing cost you need to pay to get funding for your loan.  Lenders will do a credit check, require an appraisal and process your loan for several weeks before they release any money.

Treat the entire process as though you were applying for a home purchase loan.  Prepare your pay slips and get the other documents ready to help make the process go faster.

The Repayment Process

The repayment process will depend on the type of loan that you get.  With a lump-sum loan, you need to make a fixed monthly payment (same amount every time) until you’ve paid off the loan.  With a line of credit, the bank will give you a ‘draw period’ wherein you can take out money – it can last up to 10 years.

During this time, you can make several small payments against your loan.  After this period, the bank will require you to make regular payments to pay off your debt.  In both cases, if you want to save money, just pay off your loan early.

Approval is not guaranteed

Banks are most careful about lending money because overexposure can lead to big losses. Before 2007, banks were very lenient when it came to approving loans.  However, the housing crisis drove banks to review their lending policies and tightened the requirements.  They will now actually evaluate your loan application.

Max 80% of your home’s value

To protect themselves, they’ve also set a cap to how much a homebuyer can borrow.  You cannot borrow more than 80% of your home’s value – taking into account the original purchase mortgage and any home equity loan you are applying for.  The percentage of the home’s value available is called the loan to value ratio.  This figure varies from bank to bank.

Lenders only approve home equity loans if buyers can show they have the ability to repay. Regulations require them to verify your finances and you must show proof.

Equity loans (HELs) Vs lines of credits (HELOCs) – Pros & Cons

Home equity loans (HELs) and lines of credit (HELOCs) can be an attractive option for both lenders and borrowers. Here are some of the benefits for borrowers:

Low-Interest Rates

The primary benefit of both home equity lump-sum loan and home equity lines of credit is their low interest rates. Compared to interest rates of personal loans, the interest rate for a home equity loan is much lower.

And when you compare its rate to a credit card’s cash advance financing charge, it’s even so significantly lower.  This is because, from the bank’s point of view, it is a secured loan with your home as the collateral.

Remember though, that this is also a risk.  When you use your home as collateral and if you default on your loan, the bank will most likely foreclose and take your house.  So, understand the risks before you sign on the dotted line.

Flexibility

Flexibility for homeowners with a home equity line of credit comes in having the liberty on how to spend their money.  In fact, a homeowner may not really need to draw on his line of credit.  Some homeowners keep it as a reserve knowing that it’s there in case they need money for emergencies like car repairs.

In case the emergencies don’t arise, the can just leave their lines unutilized.  If they draw on it, they must make payments for the amount they use – just like a consumer credit card.

A home equity loan, (compared to a HELOC) has less flexibility.  A HELOC is a credit line that is dependent on your equity.  Your house still serves as the collateral but you only draw funds when you need them.

This is helpful when you are only anticipating a need that may or may not come such us a new business investment.  An equity loan is a lump sum distribution – you have to specify the exact amount to borrow upfront.

Stability

Some borrowers prefer the lump-sum home equity loans because they believe it is more stable. A home equity loan has a fixed interest rate and it does not change during the life of the loan.  However, a home equity line has a variable interest rate that goes up or down depending on certain financial indices.

Once a homeowner takes out funds from a home equity loan, the money is his.  All he needs to do later is meet the monthly payments on time to pay it all back. Lenders of HELOCs can cancel the line or reduce its limit anytime as long as they properly notify their client.

Potential Tax Benefits

Your interest expenses on a home equity loan may be tax-deductible but not everybody qualifies for that.  It is best to check with your tax adviser.

Large Amounts

Borrowers can actually qualify to a large loan amount – that is granting that you have a substantial equity in the home.

If you fail to repay, the lender may foreclose your house.  It is the process of taking the property and then selling it to recover any unpaid funds.  Generally, borrowers tend to prioritize this loan over other loans because they don’t want to lose their homes.  For example, they would rather skip paying their credit card than their monthly home payment.

So, we know that a home equity loan lets you borrow money from a bank using your home as collateral.  Equity is the value of your property based on how much payment you’ve made on your first mortgage.  While equity loans offer lower interest rates than unsecured loans, there are also risks and disadvantages.

The Lien

To secure your home equity loan, the lender executes a lien against your property – the same way your original mortgage lender did.

This means that you already have an increased risk of losing your home in case you fail to meet your repayment obligations.  A sudden job loss or any financial disaster than may cause you to miss successive payments can become a serious problem.

Monthly Installments

Aside from the increased risk on the property, the monthly payments will also add up to your monthly expenses.  Not like credit lines, an equity loan requires monthly payments – just like your first mortgage.  This means that every month, the installment amount adds up until you repay the whole debt.

If you add another $200 or $300 more monthly, plus the risk of losing your house, your monthly debt could become stressfully burdensome.

Equity Reduction

Your home is a place where you live and it’s also your property investment.  By borrowing an additional amount against your equity, you will effectively lessen the net worth of your assets.

The effect is that, if ever you sell your home, you end up with less money because you have to pay off two loans.  Also, when there is an additional monthly principal and interest payments, you might not be able to pay off the first loan quickly.