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Home equity loan versus credit line: What is the difference?

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couple talking with a real estate agent about their housing financing options

The equity of a house is a key advantage of owning a house. However, you can only access it when you sell your home or apply for a home equity loan or a home equity line of credit (HELOC).

Using a loan or a credit line can be useful if you need to access a sum of money with favorable rates or low rates. There are some key differences to consider when it comes to choosing which one is best for you. See our guide below for the differences between home equity loans and home equity lines of credit.

Home equity loan versus credit line

Here is a quick definition of each option:

A home equity loan It is a lump sum of cash that is paid with fixed payments over a given period.

A home equity line of creditIt is a flexible loan that allows you to borrow and pay several times up to the maximum amount agreed by the lender, similar to a credit card.

There are some similarities between these options:

  • Collateral: Your home is used as collateral for lenders in case you cannot pay the loan.
  • Capital: Both options borrow against the value of the house you actually own, known as the net value of your home. We will go into more details on how to calculate this later.
  • Second mortgage: These options are commonly known as second mortgages, since you are requesting a loan against the value of your home.
  • Tax-deductible: The IRS He says interest payments for any of the options are potentially tax deductible if the loan is used to improve or remodel your home.

These are the key differences between the two:

Home equity loan Home equity line of credit
Money Borrow from the
credit limit
Given a lump sum in advance
Interest Typically a variable rate Typically a fixed rate
Payments Only make payments based on the amount borrowed Fixed payments during
a set time

Calculation of the capital of your house

You can determine the value of your home by subtracting the amount you currently owe on your mortgage from the value of your home.

Another number you will need to know is your Combined loan-to-value ratio (CLTV). This is a percentage that is found by dividing the total amount you owe on all mortgage loans by the market value of your home. The lower your CLTV, the lower your credit risk and the greater your chances of receiving the loan.

How to calculate the ratio between loan and value

The amount you can borrow against your capital varies greatly among lenders. For example, Discover It offers loans of up to 95 percent of its combined loan-to-value ratio. On the other hand, some lenders put a limit on the total amount you can borrow. US Bank UU.For example, it allows clients to borrow $ 750,000 and up to $ 1 million for properties in California.

Sometimes you can borrow more in exchange for higher costs and / or interest rates.

Example

Suppose you meet the income level, credit score and other requirements of a lender for a second mortgage. For this example, let's also assume the following:

  • Mortgage Loan Debt: $ 200,000
  • The value of the house: $ 600,000
  • CLTV ratio (mortgage loan debt divided by the value of the home): 33 percent
  • The lender allows a CLTV of 90 percent

With these numbers, we can find the maximum amount of debt and the amount you can borrow. The maximum amount of the debt is the total amount that a lender would lend you based on the value of your home. The amount you can borrow is the amount they will lend based on what you currently owe.

  • Maximum amount of debt (multiply the value of the home by 90 percent): $ 540,000
  • Amount you can borrow (maximum debt amount minus current mortgage loan debt): $ 340,000

Keep in mind that lenders can execute the foreclosure of your home if you do not meet the loan, since you are using your home as collateral. Make sure that the amount you borrow is a total that you are sure you can pay.

Loans with mortgage guarantee Pros and cons

Home equity loans are a consistent option that can facilitate the prediction of your monthly budget. They are also excellent if you need funds in advance for a great expense. However, you can end up paying a lot, especially at the beginning, since you are paying interest on the entire loan.

Pros

The biggest benefit of a home equity loan is its predictability. Below are some other benefits when using home equity loans.

  • In some cases, a fixed interest rate
  • Fixed monthly payments
  • Set payment period
  • It's about a amortization loan, which means that payments reduce the loan balance and cover some interest costs

Cons

Home equity loans fall short in terms of inflexibility and potentially high long-term costs. Here are some other inconveniences to consider.

  • High interest costs at the beginning since you are borrowing a large sum
  • You can pay more than your home is worth if the value of your home decreases over time

When you can use a home equity loan

A home equity loan may be a good option for those with large single expenses, such as a home renovation project.

Some also use a home equity loan to eliminate a large amount of debt, as it is sometimes more affordable to obtain a large lump sum as you are using a home equity loan compared to other loans. However, its affordability compared to other options depends largely on the financial situation of an individual.

This option is also excellent for borrowers who prefer consistent terms and want a predictable payment plan.

Home equity loans are more suitable predictable options for expenses with defined costs

HELOC Pros and Cons

HELOCs are flexible options that allow you to borrow only what you need when you need it instead of dispersing the total amount, similar to a credit card. In this way, you only pay interest on what you borrow, but as a result you have variable interest rates.

An important difference to consider between home equity loans and HELOC is that HELOC They usually have a "draw period" and a "reimbursement period."

  • The draw period It is the time when a borrower can access the funds. They can borrow and pay continuously during this time, up to the maximum amount allowed. During the withdrawal period, borrowers must pay at least the minimum monthly payment.
  • The repayment period Follow the draw period immediately. This is the time when borrowers must pay the outstanding balance.

Pros

HELOCs are excellent for those who want more flexible payment options. There are some other benefits to consider with this option.

  • Borrow only what you need
  • Pay interest only for what you borrow
  • Some offer a fixed rate loan option which allows borrowers to convert HELOC balances of variable rate into a fixed rate option
  • Some offer options delay the repayment period.
  • Any offer interest only periods that allow borrowers to pay only interest for a fixed time
  • Borrowers can keep interest costs low if they have a small or zero balance.

Cons

Variability with HELOC has a price: you can end up paying higher interest rates depending on when and how much you borrow. Become familiar with other HELOC issues.

  • Interest rates may fluctuate depending on the market and lead to higher interest debt.
  • Flexible loans can attract some to spend more
  • You may have to meet minimum withdrawal amounts and other requirements to borrow
  • Lenders can lower or close your HELOC

When can you use a HELOC

This option may be more attractive for those with expenses that occur in stages. For example, you may have a long-term home improvement project, but you are not sure how much each phase of the project will cost.

It is also an option for things like college tuition when you don't know how much help you will receive from other financial sources. With HELOC, you have the flexibility to borrow only what you need.

HELOCs are also excellent for borrowers who don't want to be locked into a long payment plan and don't want to initially borrow more than they might need.

Home equity lines of credit are flexible options that work well for expenses with variable costs

Other factors to think about

Research when you compare these offers with each other and with other options to make sure you make an informed decision. Here are some things to consider:

  • Interest rates: Although second mortgages generally offer more favorable rates than other loans, the amount that lenders offer may vary. This variability increases if you choose a HELOC.
  • Fees and penalties: Expenses such as closing costs and assessments can increase the initial cost of taking out any of the options.
  • Foreclosure Risks: Both options put you at risk of losing your home if you can't pay what you borrowed.
  • You owe more than your home is worth: You may end up paying much more than your home is worth, depending on market fluctuations and the type of loan. Home equity loans can generate a higher interest debt since their rate is blocked from the beginning. If you need to sell your home while using any of the second mortgage options, you may end up owing more than your home is worth or finish upside down of your loan.

You should also consider other types of loans and financing options depending on your needs and financial position. Work with a trusted mortgage provider or financial provider to guide you through your decision.

If you discover that your credit score is holding you back from the options you want, you can check these tips to secure a bad credit loan. If you were looking for a loan in the market because you have trouble keeping up with payments, you can also consider refinancing your mortgage.

It is possible to refinance a mortgage with bad credit, it is a little more complicated than refinance with good credit. When looking for a loan, be sure to read the fine print, research and explore all your options before making a decision.

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