What Are the Different Types of Home Equity Financing?
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Paying for college, financing home renovations and consolidating debt are just a few of the reasons that homeowners take out home equity loans or lines of credit. Whether you need a one-time lump sum of money or access to cash on an as-needed basis, these types of financing provide flexible and accessible options.
There are two main ways a homeowner can borrow against the equity in their home: a home equity loan and a home equity line of credit (HELOC).
What is a home equity loan?
A home equity loan is a debt that is secured by your home; it’s also known as a second mortgage. Generally, lenders will let you borrow at a combined loan-to-value ratio of up to 80 percent, based on your home’s current value. For example, let's say you own a home worth $200,000, with a first mortgage of $120,000. Your loan-to-value ratio is 60 percent ($120,000 divided by $200,000). You might thus be able to qualify for a home equity loan of up to $40,000, so that your combined mortgage debt of $160,000 is no greater than 80 percent of your home’s $200,000 value.
With a home equity loan, you receive a lump sum of money. These loans typically come with a fixed interest rate and have a term of five, 10 or 15 years. The interest rate you qualify for will depend in part on your credit scores, which are generated from information on your credit reports.
A home equity loan may be beneficial if you need a set amount of money at one time and nothing more.
Another option: a home equity line of credit
A HELOC, though also secured by your home, works differently than a home equity loan. In this type of financing, a homeowner applies for an open line of credit and then can borrow up to a fixed amount on an as-needed basis. The homeowner only pays interest on the amount that is borrowed.
Typically, a HELOC will remain open for a set term, perhaps 10 years. Then the draw period will end and the loan amortizes — that is, you begin making set monthly payments — for perhaps 20 years.
The main benefit of a HELOC is that you only pay interest on what you borrow. Say you need $35,000 over three years to pay for a child’s college education. With a HELOC, your interest payments would gradually increase as your loan balance grows. If you had instead taken out a lump-sum loan for $35,000, you would have been stuck paying interest on the entire amount from day one.
Which home equity loan is better for you?
The right home equity financing for you depends entirely on your situation. Typically, HELOCs will have lower interest rates and greater payment flexibility, but if you need all the money at once, a home equity loan is better. If you are trying to decide, think about the purpose of the loan. Are you borrowing so you’ll have funds available as spending needs arise over time or do you need a lump sum now to pay for something like a kitchen renovation?
A home equity loan offers borrowers a lump sum with an interest rate that is fixed but tends to be higher. HELOC, on the other hand, offers access to cash on an as-needed basis, but often comes with an interest rate that can fluctuate.
As a borrower, it pays to shop around and ask a lot of questions to ensure that you are getting the right financing for you at the best rate possible.