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Is Your Home Equity Line of Credit (HELOC) a Trap?
Do your homework before opening a HELOC.
What Does It Mean When a Home Loan Has a Draw Period?
Hint: You get access to cash.
The Only 4 Reasons to Use Home Equity Loans
Home equity loans are a way to get cash quickly/
There’s often confusion between home equity loans versus HELOCs (home equity lines of credit). Though both let you tap your home equity for cash, they function quite differently. HELOCs act as a line of credit, much like a credit card, while home equity loans offer a lump-sum payment all at once. Funds from both products can be used as the borrower sees fit.
What is home equity?
To understand home equity loans and HELOCs, you first have to understand home equity. Put simply, equity is the share of a home or property you actually own. To calculate how much equity you have, start with your home’s value and then subtract your remaining mortgage balance.
For example, if your home appraises for $280,000 and your current loan balance is $150,000, you have $130,000 in equity. As a percentage, you have a 46.42% equity stake.
Financial products like home equity loans and HELOCs allow you to borrow against this equity up to a certain point -- typically 80% to 85% for most lenders. You can use the funds to pay for home renovations, medical bills, tuition costs, or any other expenses you might have coming your way. You can also use home equity products to consolidate and pay off higher-interest debts like credit cards and personal loans.
Leveraging your home equity
Home equity products come with both pros and cons. On the plus side, home equity loans and HELOCs are fairly easy to come by since they’re secured by an asset. You’ll need decent credit, sure, but the main requirement with these loans is that you have equity in your home. The more you have, the better.
Another major benefit is that home equity loans and HELOCs offer much lower interest rates than other financial products. If your other options are personal loans or credit cards (which often have double-digit APRs), a home equity product can save you a lot of money.
Finally, interest on home equity loans and HELOCs is often tax-deductible as long as you use the funds to improve your property. This perk isn’t available on other financial products and can equal big savings over time.
There are downsides, though -- primarily, putting your home at risk. Since home equity products use your property as collateral, you could find yourself in danger of foreclosure if you fall behind on payments. If you opt for a home equity loan, this risk is even higher.
Home equity loans act as second mortgages, meaning you’ll need to make two mortgage payments each month to stay afloat. HELOCs often require smaller, interest-only payments for the first 10 years or so, making them easier to manage -- at least at the outset.
There are also costs to consider. Just like with your first mortgage loan, home equity products come with closing costs and fees. On HELOCs, you might even see fees each time you make a withdrawal. These can add up over time, especially if you expect to make several transactions over time.
|Advantages of Home Equity Products||Disadvantages of Home Equity Products|
|Easy to come by if you have significant equity||Put your property at risk|
|Lower interest rates than other financial products||Add a second monthly payment|
|Interest may be tax-deductible||Come with closing costs and regular fees|
What is a HELOC?
A HELOC, or home equity line of credit, offers a credit line you can pull from as needed (usually via payment card, checks, or some sort of digital transfer mechanism). They work much like a credit card, allowing you to withdraw funds over an extended period of time.
This period, called the "draw period," usually lasts up to 10 years. During this time, you’ll typically make interest-only payments on the amount of money you’ve taken out (not your full credit line).
After the draw period is up, you’ll enter the repayment period, in which you’ll start to repay the money you borrowed plus interest. This period usually lasts from 10 to 20 years.
HELOCs typically come with a variable interest rate, meaning the rate will fluctuate over time. You’ll usually get a low promotional rate at the beginning of the loan, and the rate will increase as you get into the repayment period. If you’re considering a HELOC with a variable rate, it’s important to consider any caps your lender might put in place. Many lenders cap the number of rate increases you can experience in any given year as well as over the life of the loan. Some lenders may even let you convert your variable interest rate into a fixed one for a fee.
Important note: HELOCs allow you to tap your home equity, but you don’t have to use the full amount offered to you by your lender. You can withdraw only the money you need as you need it.
Pros and cons of HELOCs
HELOCs come with major pros and cons. Here's what you need to know.
Advantages of HELOCs
- They let you use (and pay interest on) only the funds you actually need. Compared to other loan products, which give you a lump sum payment whether you need it or not, this can be a huge perk.
- They're very affordable. Even with variable rates, HELOCs are more affordable than many other financial products. According to Bankrate, the average rate on a HELOC in November 2019 was 7.12%. Credit cards averaged more than 10 percentage points higher (17.55%) around the same time.
- Interest can be tax-deductible if you're making home repairs or renovations. You can still only deduct interest on up to $750,000 worth of mortgages (per the Tax Cut and Jobs Act of 2017), but unless you have a high-cost property (or several properties), you should be safe to enjoy the write-off.
Disadvantages of HELOCs
- Interest rates are often variable. Not only can your interest rate and payments increase, but they’re also inconsistent and hard to budget for. If you’re dealing with limited or fluctuating income, this might cause serious financial stress down the line.
- Some HELOCs come with transaction fees. They're charged every time you make a withdrawal. If you make lots of withdrawals, these fees can significantly increase the cost of your loan over time.
- They're revocable. If your finances change, your home value decreases, or the housing market takes a turn, your lender could reduce or even close your line of credit. If you’re relying on those funds for something important, this might be too big a risk to take.
|HELOC Pros||HELOC Cons|
|Can pull funds as needed||Variable interest rates may rise over time|
|Only pay interest on what you use||Inconsistent payments may be hard to budget for|
|Low, interest-only payments during withdrawal period||Puts your home at risk|
|Interest may be tax-deductible||May come with transaction fees for every withdrawal|
What is a home equity loan?
A home equity loan is like a traditional mortgage loan in that you’re given a lump sum all at once, rather than a line of credit you can draw from at will. You then pay the balance back month over month across your loan term, which typically ranges from five to 30 years.
Because home equity loans can give you access to large amounts of cash at once, they’re often a smart choice if you have a big expense you’re dealing with.
As with HELOCs, home equity loans use your home as collateral. The big difference is that they come with fixed interest rates instead of variable ones. This ensures a consistent monthly payment for the entire loan and makes them easier to budget for.
Pros and cons of home equity loans
Of course, there are upsides and downsides to home equity loans. Here are some you should know:
Advantages of home equity loans
- Payments are consistent, reliable, and easy to budget for. If you’re on a fixed income, this can be highly beneficial -- especially compared to variable-rate products like HELOCs and credit cards.
- They pay one-time lump sums. This is nice if you have a large expense or many expenses coming due at once. It also reduces your fees. While you’ll pay closing costs upfront to secure the loan, you won’t incur fees or charges over time (like the transaction fees that often come with HELOCs).
- They may be tax-deductible. Like HELOCs, if you're using the funds for home repairs or renovations, you can deduct the interest from your taxes (up to $750,000 in mortgage debt).
Disadvantages of home equity loans
- A second monthly mortgage payment. And it can be a significant one. This can make staying afloat difficult and, because the loans use your home as collateral, can also put your home at a higher risk of foreclosure.
- Inflexible lending amounts. If you think you’ll have recurring expenses or you’re just not sure how much a project will cost you, you might be better offer with a product that’s more flexible in terms of funding. (You don’t want to take out too much and pay interest on unnecessary funds.)
|Home Equity Loan Pros||Home Equity Loan Cons|
|Offer a large, lump-sum payment||Puts your home at risk|
|Fixed interest rates||May mean paying too much in interest if you don’t estimate the funds you need accurately|
|Consistent, reliable payments that are easy to budget for||Adds a second mortgage payment|
|No recurring or transaction fees|
|Interest may be tax-deductible|
Home equity loans vs. HELOCs
Now that we’ve covered the basics, let’s look at home equity loans vs. HELOCs feature by feature.
Interest rates: Home equity loans come with fixed interest rates, while HELOCs come with variable interest rates that can change over time. In the beginning, home equity loans tend to have higher interest rates than HELOCs, due to the protection the fixed-rate provides the borrower.
Payment methods: Home equity loans offer a lump-sum, upfront payment based on your equity stake. HELOCs offer a line of credit that you can pull from as needed.
Terms: Both loans can go up to 30 years, though you can typically only withdraw money from HELOCs for 10 years at the most. You’ll repay home equity loans (balance plus interest) month over month, as you would a traditional mortgage loan. Most HELOCs require interest-only payments until the withdrawal period is up.
Fees: Both loans come with closing costs. HELOCs, though, often have transaction fees you’ll pay each time you withdraw funds. Home equity loans typically don’t have recurring fees.
Taxes: The interest you pay on both HELOCs and home equity loans can be tax-deductible. In both cases, you’ll need to use the funds to improve your home’s value (renovate it, repair it, etc.) if you want to write off your interest.
Uses: Though many people use home equity loans and HELOCs to make changes around the house, there are no limitations on how these financial products can be used. You can use them for home maintenance costs, bills, education costs, or even vacations (though that may not be advisable).
|Loan Feature||Home Equity Loans||HELOCs|
|Interest rates||Fixed||Usually variable|
|Payment method||Lump-sum||Draw period|
|Tax-deductibility||Only if used on home renovations||Only if used on home renovations|
|Repayment term||5 to 30 years||10 to 30 years|
|Use||Funds can be used on anything||Funds can be used on anything|
|Closing Costs||Typically higher than HELOCs||Typically lower than home equity loans|
Home equity loans vs. HELOCs: Which should you use?
Choosing between home equity loans vs. HELOCs comes down to how much money you need, how predictable your expenses are, and your current financial limitations.
The first thing you’ll want to think about is what you intend to use the money for. Generally speaking, a home equity loan is going to be best if you have a large, predictable, one-time expense to cover, like a new roof, a major car repair, or consolidating other debts. If your costs are less predictable or you expect them to recur over time (like tuition bills or medical treatments), a HELOC may be a better option, as it allows you to pull funds as needed across an extended period of time.
Next, think about your financial situation. How predictable is your income? Do you need consistent payments that you can easily budget for, or can you afford more fluctuation? If you need consistency, a home equity loan is your best bet. These come with fixed interest rates and predictable payments for the entire loan term. If you can deal with some ebb and flow, a HELOC could be an option. Just make sure you’re prepared for a big jump in payments once your withdrawal period ends.
|...your income will likely increase over time||HELOC|
|...you’re on a fixed or unpredictable income||Home equity loan|
|...you need a low payment now, but can afford a larger one years down the line||HELOC|
|...you’re not sure how much your expenses will be, and you need flexibility||HELOC|
|...you have a predictable, one-time expense||Home equity loan|
|...your expenses will be recurring or spread out over time||HELOC|
|...you’re consolidating higher-interest debts and want a fixed, manageable payment plan||Home equity loan|
|...you’re financially prepared for increasing rates and payments down the line||HELOC|
|...you need a consistent, predictable payment across your entire loan term||Home equity loan|
|...you can cover the required transaction and withdrawal fees||HELOC|
Home equity products vs. cash-out refinancing
If you’re set on tapping your home equity, HELOCs and home equity loans aren’t your only option. You might also consider a cash-out refinance. This allows you to replace your existing mortgage loan balance with a new, larger loan. You then take the difference between the two in cash, which you can use toward home improvements or any other expense, just like HELOCs and home equity loans.
The main difference here is that you’re not adding a second payment. Instead, you’re replacing your existing loan payment with a new one. It might be higher, lower, or the same as your old one; it all depends on the loan term, interest rate, and total loan balance.
Regardless, cash-out refinancing can be a smart choice because it
- keeps you to one mortgage payment per month,
- offers fixed interest rates and reliable costs for the entire loan term, and
- gives you a large lump sum to use however you see fit.
If interest rates are low or you refinance into a longer-term loan, you might even be able to lower your mortgage payments in the process, saving you both now and over the long haul.
Do you have mortgage insurance attached to your current loan (i.e., you have an FHA loan or made a small down payment on your conventional loan)? Refinancing may help there, as well. If you can refinance into a conventional loan and you have at least a 20% equity stake in the property, you can avoid mortgage insurance altogether (as well as the monthly costs that come with it).
A quick note: Though refinances come with closing costs and other up-front fees, some lenders let you roll these into your loan balance and pay them off over time.
Home equity products vs. other options
Of course, your home equity isn’t the only source of cash for homeowners. You can also look to more traditional financial products like personal loans and credit cards, if you’d like.
Both of these options come with significantly higher interest rates than home equity loans or HELOCs, as they’re unsecured loans -- they’re not backed by an asset that protects the lender. They also won’t come with any tax write-offs, even if you use the funds toward improving your property.
A final consideration is the amount of financing you’re needing. Most personal loans won’t go higher than $100,000 (even with sterling credit), and credit cards are typically a small fraction of that. This makes neither an ideal choice if you have large expenses on your radar.
There's a silver lining, though: Both credit cards and personal loans offer quick turnarounds. You can typically get funding on a personal loan within just a few days, and most new credit cards are mailed out within the week. If you need super-quick cash, they might be worth pursuing.
The bottom line
As a homeowner, there are several ways you can leverage your property to access cash. In most cases, these offer a more affordable financing option than credit cards, personal loans, and other high-interest products.
Still, rates, fees, and terms on these loans can vary greatly, so it’s important to shop around before deciding which one to use. Get quotes from several lenders and make sure to compare each estimate carefully.
Don’t be afraid to negotiate, either, and pay close attention to the “services you can shop for” portion of your loan estimate. You may be able to save on these fees and services by shopping around on your own rather than using the providers recommended by your lender.
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