HELOC and Home Equity Loan FAQs

Home equity is a huge benefit of being a homeowner. It can become a great asset if you need funds for home improvements, education expenses, and much more. Two common means of turning equity into cash are home equity lines of credit (HELOC) and home equity loans. Both have various advantages, but it is also important to be aware of the potential drawbacks before you decide which type of equity loan is right for your needs.

In this article, we will be answering the most common questions borrowers ask, along with going over some pros and cons so you can determine which equity loan you want to use.

How does a HELOC work?

First, we will start with home equity lines of credit (HELOC). What separates HELOCs from their home equity loan counterparts is how they work. Rather than receiving a lump sum of cash, a HELOC provides you with the ability to withdraw funding as you need it.

Generally, there are two periods—a draw period and a repayment period. For example, there may be a 10-year draw period and a 20-year repayment period. During the first 10 years, you can draw funds for anything you like. Plus, you only have to pay for interest and your payment can be quite low (though you are 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 again. It acts as an open line of credit, and if you stay within budget then it is possible you could even pay off the HELOC during the initial draw period. Otherwise, during the 20-year repayment period, your loan is fully amortized and you are no longer able to draw money from the line of credit. That means you will have a payment that is both interest and principal, so it will likely be higher than your interest-only payments.

What is a home equity loan?

Unlike a HELOC, with a home equity loan you receive all of your funds 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. That fixed rate will most likely be higher, but you will have a predictable payment, and you will be paying down your principal. 

However, not all lenders offer home equity loans as an option, so it is important to discuss it with your preferred lender.

What is the difference between a HELOC and a home equity loan?

If you decide a HELOC is the right option for your needs, keep in mind that the rate can adjust monthly once you enter its repayment period. You typically pay interest only during the initial draw period, but you can also pay extra toward the principal upon request. However, with a HELOC, you are able to withdraw money from the line of credit as you need it, and you will only pay interest on the amount that you withdrew.

A home equity loan is different as you start with a fixed rate and receive your cash in one lump sum. Unlike a HELOC, in which you only pay back the amount you withdrew, a home equity loan will require you to pay back the full amount you initially received—whether or not you ended up using all of the funds.

This differentiating factor is what makes HELOCs the more popular loan option for homeowners interested in starting home improvement projects. A HELOC can provide more flexibility in your budgeting, whether you need more funds than anticipated or end up completing the project at a lower price point.

HELOC and home equity loan FAQs answered

Now that we have defined the differences between HELOCs and home equity loans, we will answer some of the most frequently asked questions borrowers have:

How much equity do you need to get a HELOC?

Every lender has their own requirements on how much equity you will need for a HELOC. They look at what your home is worth and the total amount of loans against the property value. This is called the combined loan-to-value ratio (CLTV). It is the total of your first, second, and third mortgages compared to the value of the home. Here is an example:

• $200,000—First mortgage

• $75,000—HELOC (second mortgage)

• $400,000—Home value

The calculation would be CLTV = $275,000 divided by 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 is why it is better to be conservative when borrowing against your home. The type of property also affects the interest rate. You will get the lowest rate on a single-family home. For a condominium, your interest rate may be higher. 

Should you use a HELOC for home improvements?

Getting a HELOC to fund renovations can be an excellent idea. If you use your HELOC for home improvements, ask your accountant if they are tax-deductible. Tax rules change all the time, but the HELOC interest you pay may be tax-deductible, so be sure to save your records and receipts.

A HELOC for renovations can also provide you with an excellent route for building even more equity if you stay within your budget and understand the values of the current real estate market.

Is it a good idea to use a HELOC to buy a rental property?

Before the crash of 2008, many homeowners did just that. With soaring real estate prices, they felt that they could not go wrong. But then the market crashed, and they owed more on their home than it was worth. That is not to say that you should never use your HELOC funds to invest in other properties, but it is best to use caution. Using equity in your home should not be taken lightly, as your home will act as collateral for the loan. Instead, it is crucial to weigh all of the pros and cons and take a conservative approach. 

That said, leveraging your equity to invest could be a good idea if you have experience or can work with someone who has rental properties and can guide you. When it comes to using your equity, it is best not to take big chances. For example, if you are considering buying a property that needs significant work before you can rent it—beware—especially if you do not have construction skills or the experience you need to make sure the project comes in on budget. It is important to feel confident you can pull it off successfully. That is why it is 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. 

Should I use a HELOC to pay off credit card debt?

Although that answer does not come down solely to interest rates, paying off high-interest credit cards with your HELOC funds could be a smart move. Keep in mind, credit card debt and personal loans through a credit union or a bank are “unsecured”.

Your home secures a HELOC. So, it is a bigger decision that should not be taken lightly. Some financial advisors advise against paying off debt with a HELOC. But, if you can pay off your debts faster with less interest, a HELOC or home equity loan could be a good solution.

A smart way to calculate if a HELOC or credit card is better for you, is by comparing how much interest you will pay over time until the debt is paid off. Do not let paying off credit card debt with your home's equity be a temporary solution to your financial problems, though. 

It is essential to address the source of your debts and come up with a solution. Do you need to make more money, live within your means, or both? You do not want to get a HELOC without changing your spending habits and risk running up more credit card debt. 

Can you refinance equity loans?

Yes, you can refinance a home equity loan or HELOC. Every bank has its own rules, although many do not 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 covered them for you. When comparing lenders, besides looking at interest rates, compare closing costs and any annual fees. 

Refinancing anything all comes down to costs in comparison to savings. Make sure you do not only look at the monthly payment and see how much interest you will be paying over time. If you are 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 depending on the overall market. However, HELOC rates are usually a bit lower than fixed home equity loans. With a HELOC, you only draw funds as you need them. For example, if you are doing some home remodeling, you might not need all the money at once. 

Some lenders also offer an interest-only payment option where you would be paying only interest during the initial draw period. After that, you would pay principal and interest. Having a lower payment is very helpful if you are 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 would 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 is 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 have drawn all you need from the loan, you will have a predictable payment. 

What are home equity loan rates?

Similar to 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. 

Is an equity loan a mortgage?

Yes, both a HELOC and a fixed-rate home equity loan are considered a mortgage. That is 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 do not 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 will need an appraisal, but sometimes the lender can use an automated system and verify the property value without having an appraiser come out. You will also need title work, but it should be less expensive than getting a regular mortgage. 

Is a HELOC right for you?

Whether or not a HELOC is the right option for you depends on how you plan to use the funds. Suppose you are considering using a HELOC to pay off high-interest debts. That could work if you pay more than the minimum payment. Otherwise, if you stretch out the loan term, you could end up paying more interest and you will 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. Home improvements are the most popular use of HELOC funds, as they often increase the value of your home, therefore increasing your equity or securing more profit if you plan to sell it. There are many different options and considerations when it comes to HELOCs and home equity loans. If done correctly—you can use these equity loans to upgrade your home, invest in real estate, or get out of debt. It is important to take the time and do the math so you can better understand what works best for you. 

You will also want to reach out to your mortgage lender and discuss what options they have available. Not all lenders offer home equity loans for instance, and if your preferred lender does not, then you will want to ask how their HELOC products compare to other offerings on the market.