February 18, 2022
HELOCs & Home Equity Loans — Top FAQs
Today we’re going to discuss taking advantage of the equity in your home by getting a variable home equity line of credit (HELOC) or a fixed home equity loan. Although there are some major advantages to these types of equity loans, there are also some drawbacks to keep in mind. Let’s look at the pros and cons and answer the most common questions borrowers have.
How does a HELOC work?
If you’re wondering, “What is a HELOC?” It’s different from a traditional 30-year fixed mortgage. Generally, there are two periods — a “draw period” and a “payback period.”
For example there may be a 10-year draw period and a 20-year repayment period. During that first 10-years, you can draw funds for anything you like. Plus, you can pay interest only and your payment can be quite low, but you’re not paying down the principal.
Also, during that initial draw period, you can draw money out and pay it back, draw money out again and pay it back. It’s an open line of credit.
Then during the 20-year repayment period, your loan is fully amortized. That means you’ll have a payment that is both interest and principle. And it could be quite a bit higher than your interest-only payment. If you kept the loan the entire time, it would be paid off at the end of the 20-years.
What’s the Difference Between a HELOC and a Home Equity Loan?
A HELOC has variable interest that’s usually attached to the prime rate. Lenders add the current prime rate to a percentage (that’s their profit) to give you the interest rate on your loan. That rate rises and falls with the prime but is always more than prime since it has the extra added percentage from the lender. With a HELOC, the rate can adjust monthly — each lender’s program is different.
As discussed above, you pay interest only during the initial draw period (although you can pay more). After that — your loan is fully amortized.
With a HELOC, you only take out the money you need when you need it. And you only pay interest on the amount that you take. A home equity loan is different.
What is a home equity loan?
With a home equity loan, you take all the funds at the beginning of the loan in one lump sum. The interest on a home equity loan is fixed, and the payment is amortized. That means you pay principal and interest, and your loan is paid off at the end of the term.
Some lenders offer an initial line of credit with interest-only payments. Then, later once you’ve borrowed as much as you need, you can convert the variable rate into a fixed rate. That fixed rate will most likely be higher. But you will have a predictable payment, and you will be paying down your principal.
Should I Use a HELOC for Home Improvement?
Home equity lines of credit are one of the most popular loans for home improvement projects. If you have a property, you’d like to upgrade and keep or sell — getting a HELOC to fund the renovations can be an excellent idea.
If you use your HELOC for home improvements, ask your accountant – Is a HELOC tax-deductible? Tax laws change all the time, but the interest you pay may be tax-deductible, so save your records and receipts. Consult a tax adviser for further information regarding the deductibility of interest and charges.
Using a HELOC to renovate your home is a good way of building even more equity as long as you stay within budget, know the values of the current real estate market, and don’t over-renovate. You don’t want to upgrade over the neighborhood’s sale prices and not be able to make your money back.
For example, adding a second story to your home if all other houses are only a one-story might not be the best plan. But renovating your kitchen and bathroom if most homes nearby are upgraded is wise — especially if you’re planning on selling and want top dollar.
Is It a Good Idea to Use a HELOC to Buy a Rental Property?
What about investing in real estate using your home equity? Before the crash of 2008, many homeowners did just that. With soaring real estate prices, they felt that they couldn’t go wrong. But then the market crashed, and they owed more on their home than it was worth.
That commentary isn’t meant to scare you or dissuade you from investing. But it is a tale of caution. Using equity in your home should not be taken lightly. Instead, it’s crucial to weigh all of the pros and cons and take a conservative approach.
That said, leveraging your equity could be a good idea if you have experience or can work with someone who has rental properties and can show you the ropes. When it comes to using your equity, it’s best not to take big chances. For example, if you’re considering buying a property that needs significant rehab work before you can rent it — beware — especially if you don’t have construction skills or the experience you need to make sure the project comes in on budget.
When you use the equity in your home, you are risking it. So, you want to make sure that you have as much data as possible before pulling the trigger if you’re planning on reinvesting some of your equity into a rental property.
It’s important to feel confident you can pull it off successfully. That’s why it’s wise to work with a real estate agent that knows the rental market. That way, you can utilize their knowledge and make the best choices.
Is it Better to Pay Off a HELOC or Invest?
With a HELOC, you have the option to pay it off and then draw from it again during the draw period. So, if you want — you could pay your HELOC down and then use the available funds for the down payment on another property.
But be conservative. If you’re investing in a property that’s undervalued and you’re walking into equity, it could be a good idea. But if you’re using your equity for a property that needs a lot of work and you wouldn’t be able to get it to cash flow for months, you could be headed for trouble.
Should I Use a HELOC to Pay Off Credit Card Debt?
Although that answer doesn’t come down solely to interest rates, paying off high-interest credit cards could be a smart move. Keep in mind, though, credit card debt and personal loans through a credit union or a bank are “unsecured.”
Your home secures a HELOC. So, it’s a bit bigger of a decision that shouldn’t be taken lightly. Some financial advisors like Dave Ramsey advise against paying off debt with a HELOC. But, on the flip side — if you have discipline and you can pay off your debts faster with less interest — a HELOC or home equity loan could be your best solution.
A smart way to calculate which is better, a HELOC or credit card, is by comparing how much interest you’ll pay over time until the debt is paid off. Don’t let paying off credit card debt with your home's equity be a band-aid to your financial problems, though.
It’s essential to address the source of your debts and come up with a solution. Do you need to make more money or live within your means or both? You don’t want to get a HELOC, not change your spending habits and run up more credit card debt.
Is It Better to Get a HELOC or Cash-out Refinance?
You’ll need to run the numbers on this scenario. But, when interest rates are low, it’s probably a better idea to get the lowest rate possible on your first mortgage. Then, once your first mortgage closes — get a HELOC.
Here’s why. A rate and term refinance offers lower interest than a cash-out refinance. So, when you get a low rate for your first and a great deal on a HELOC or equity loan, you could pay less interest than with a cash-out refinance.
You can use a mortgage calculator to check the interest on a rate and term refinance vs. a cash-out refinance. The rate for a cash-out could be .25% more or higher. Plus, with a mortgage, you’re spreading your debt over a longer period which could mean you’re paying more interest.
With a low first mortgage and a HELOC, you can pay off the HELOC early and keep your low interest first. You may pay less interest over time that way.
Can You Refinance a Home Equity Loan?
Yes, you can refinance a home equity loan or HELOC. Every bank has its own rules, although many don’t have a pre-payment penalty. But if you close the HELOC within the first few years, you might have to reimburse closing costs if the lender paid those for you.
When comparing lenders, besides looking at interest rates, compare closing costs and any annual fees.
Refinancing anything — student loans, HELOCs, or even auto loans all come down to costs vs. savings. But make sure you don’t only look at the monthly payment. See how much interest you’ll be paying overtime. If you’re stretching out the repayment term, you could also be adding additional interest.
What Are HELOC Rates?
HELOC rates are variable, so the payment can go up and down. HELOC rates are usually a bit lower than fixed home equity loans.
With a HELOC, you only draw out the funds as you need them. For example, if you’re doing some home remodeling, you might not need all the money at once.
This year you want to renovate the kitchen, so you withdraw $50,000. Then next year, you remodel your two bathrooms, so you need another $20,000. The advantage of a credit line is that you only withdraw the funds as you need them, so you’re not paying interest on money you’re not using.
Some lenders offer an interest-only payment option where you’d be paying interest-only during the initial draw period, and after that, you’d pay principal and interest. Having a lower payment is very helpful if you’re renovating your home to sell and will pay off the loan with the proceeds.
Keep in mind with interest-only payments — you would not be paying down the principal of your loan at all. You’d only be paying the interest, so your balance would stay the same.
Although every lender has its guidelines, a common way HELOC interest is calculated is as follows. Sometimes there’s a low introductory rate. After that, the rate will increase. Often the rate is calculated by adding the prime rate to a margin.
Additionally, some lenders offer an option to fix all or part of the HELOC interest. That way, once you’ve drawn all you need from the loan — you’ll have a predictable payment.
What are Home Equity Rates?
Just like with mortgage rates, home equity rates vary from lender to lender. If mortgage rates are low, home equity rates are probably low too.
Unlike HELOCs, home equity loans are fixed. The rates are higher than mortgage rates and HELOCs but lower than most credit cards. The loan is amortized over time, and at the end of the term, your loan is paid off.
How Much Equity Do You Need for a HELOC?
Every lender will have its rules on how much equity you’ll need for a HELOC.
They look at what your home is worth and total loans against the property. That’s called the combined loan-to-value (CLTV). This is the total of your first, second, and third mortgages compared to the value. Here’s an example:
- $200,000 — First mortgage
- $75,000 — HELOC (second mortgage)
- $400,000 — Home value
The calculation would be CLTV = $275,000 vs. the value of $400,000. That equals 68.75% CLTV. Some lenders will lend up to 90%, but the higher the CLTV, the higher the interest rate.
There is a risk of your property value declining, and with a 90% CLTV, you could be underwater. That’s why it’s better to be conservative when borrowing against your home.
The type of property also affects the interest rate. You’ll get the lowest rate on a single-family home. For a condominium, your interest will be higher.
Is a Home Equity Loan a Mortgage?
Yes, both a HELOC and a fixed-rate home equity loan are considered a mortgage. That’s because these loans are secured by real estate. It can be a first or second mortgage, depending on how many loans you have on the property. For example, if you don’t have a mortgage on your home and get a home equity loan, it would be in the first lien position.
With any type of equity loan, you’ll need an appraisal, but sometimes the lender can use an automated system and verify the property value without having an appraiser come out. You’ll also need title work, but it should be less expensive than getting a regular mortgage.
Should I Do a Home Equity Line of Credit?
Suppose you’re considering using a HELOC to pay off high-interest loans and credit cards. That could work if you have discipline and pay more than the minimum payment. Otherwise, if you stretch out the loan term, you could end up paying more interest, and you’ll be securing the loan with your real estate.
If you have landlord or construction experience — investing in another property using a HELOC could be a good idea as long as you know the market and stick to a budget and timeline.
As you can see, there are many different options and things to consider when it comes to HELOCs and home equity loans. Just crunch the numbers to see what works best for you.
If you’re financially savvy — you can use these equity loans to upgrade your home, invest in real estate, or get out of debt. We hope this information has been helpful to you. Here’s to a strong financial future.