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What Is Home Equity? HELOCs and Home Equity Loans
What you'll learn:Home equity and home equity loans defined; how a line of credit works
EXPECTED READ TIME: 6 MINUTES
Updated July 05, 2023
What Is Home Equity? HELOCs and Home Equity Loans
A home equity loan or line of credit can provide the funds you need for a renovation, second home purchase, or even high-interest debt relief. Are you wondering: How does equity work? What is involved in a home equity loan? What is an equity line of credit? You’ve come to the right place. Let’s take a look at what home equity is and then explore the ways you may want to turn it into cash through a home equity loan or HELOC.
First: What is home equity?
Equity in a house is the amount of your home you actually own. If you’re like most people, and took out a mortgage to pay for your home, your equity is based on how much of your mortgage is paid off.
Wondering what to do with home equity? Once you have enough equity, you have the option to access it for a variety of needs. Some of the most common uses for home equity include:
- Home upgrades Debt consolidation
- Paying off student loans
- Planning for future education
- Emergency expenses
How does home equity work?
Is home equity based on market value? Yes. Equity is determined by subtracting what you owe on a property from its current market value. Here’s the simple formula:
Home Equity = (Current Market Value) – (Mortgage Balance)
For example, let’s assume you’ve been living in a home you purchased for $500,000. You do some research and understand the current market value to be approximately $650,000. In reviewing your outstanding debt on the home (including all loans, such as a second mortgage), you still owe $400,000. Your equity is calculated by taking the value ($650,000) minus the debt ($400,000). The balance – your equity – is $250,000.
How do I check the equity in my home?
First, determine the current value of your home. To do this, you can use online tools and talk to a real estate agent to get a better understanding of your home’s value. If you decide to get a loan based on equity, the lender is likely to require a more formal process, which typically includes an appraisal that confirms the actual current home value.
How do I access my home equity?
Are you considering home improvements or need cash for an emergency or a way to consolidate high-interest debt? There are many ways you can leverage the equity in your home. Often the best way to use the equity in your home is to further increase the home’s value through upgrades. That may be a new kitchen, or energy-efficient windows or appliances.
In any of those cases, a home equity loan or line of credit could be a great solution.
Get a lump sum with a home equity loan
Want all of the cash from your equity up front? A home equity loan leverages the value you have in your home to provide the funds you need right away.
What is a home equity loan?
This type of loan uses your home as collateral to provide an interest rate that is typically lower than what you’d find for other loan types. It is a new loan separate from your original mortgage.
How does a home equity loan work?
The process for getting a home equity loan is similar to that of other mortgage types. If approved, you receive the funds all at once. You’ll begin making payments right away on a schedule separate from your original mortgage.
- Typically has a lower interest rate that’s fixed for the life of the loan.
- Since the interest rate is fixed, you’ll know what your payments are for the life of the loan and can budget accordingly.
- Won’t impact your first mortgage if you want to keep those terms.
- Often offered for shorter terms, which can mean less interest paid over the life of the loan.
- You’ll pay interest on the whole amount whether or not you use all the cash.
Access cash when you need it with a HELOC
An alternative option is a home equity line of credit (HELOC). Instead of getting your cash all at once, you leverage the equity from your home as you need it.
What is a HELOC?
Like a home equity loan, a HELOC uses your home as collateral to access your equity. But you can pull as little or as much cash as you need, when you need it, often for up to 10 years. You pay interest only on the funds you withdraw.
How does a HELOC work?
A HELOC has two periods: the draw period and the repayment period. During the draw period, you can access the cash whenever you want it, and the payments you make during this time are interest-only. When you reach the repayment period, you begin making regular monthly payments with principal and interest, which is variable based on current market trends.
- Take only as much money as you need, as you need it, during the draw period.
- Pay interest only on the amount you draw.
- Typically has a low introductory interest rate.
- Usually has lower closing costs.
- Acts like a credit card but often with a higher balance and lower interest rate.
Wondering what to use a HELOC for? While home equity loans are nice if you need the cash up front and prefer a fixed payment, HELOCs offer tons of flexibility. You access the funds only as you need them and pay only for what you borrowed. You may prefer a HELOC if you have one or more ongoing projects and don’t know the total costs up front.
|
Home Equity Loan |
HELOC |
Access to cash at closing |
Yes – lump sum |
Yes – line of credit |
Home used as collateral |
Yes |
Yes |
Interest rate |
Fixed |
Variable |
Repayment schedule |
Defined payments |
Variable payments |
Funds can be used for |
Anything |
Anything |
You may also like: The Differences Between a Home Equity Loan and HELOC
How to get a home equity loan or HELOC
Once you’ve determined your home’s equity and which option best suits your needs, you can apply for a home equity loan or HELOC. Typically, you’ll need the following to qualify:
- Credit Score – A high credit score tells a lender you have a responsible history with debt. It’s typically required to have a score of at least 620. A higher score usually leads to a better interest rate.
- Loan-to-Value (LTV) Ratio – LTV is a total of all mortgage debt divided by your home’s current appraised value. Lenders typically prefer an LTV under 80 to 85 percent.
- Debt to Income (DTI) Ratio — This ratio compares your total debt to your income. You can calculate DTI by adding all your monthly debt payments, such as credit cards and car payments, and dividing the total by your gross (pre-tax) monthly income. Strive for 43 percent or lower.
- Proof of Income – Be ready to provide your lender pay stubs, bank statements, and other necessary mortgage documents as documentation that you have resources to repay the loan.
With ample equity and a favorable financial position, you’re well on your way to accessing the equity in your home. Just remember that leveraging equity is using your home as collateral for a new debt before contacting a home equity loan lender you trust.
Want more helpful resources? Visit the Mortgage Knowledge Center.
