With mortgage rates high and economic uncertainty looming, there is good news for borrowers who already have a mortgage and may be looking to tap into their equity.
According to Black Knight’s Mortgage Watch report, the country’s housing equity position remains strong compared to its position at the start of the pandemic, with equity positions of $5 trillion, or 46 %, above pre-pandemic levels. The average mortgage holder is up more than $92,000 from the start of the pandemic.
Home equity loans and home equity lines of credit (HELOCs) are both loan products secured by the equity in a borrower’s home.
But what is the best option for your borrower? Keep reading to find out.
What is a home equity loan?
A home equity loan — also called a second mortgage, home equity installment loan, or home equity loan — is a fixed-term loan based on the equity in a borrower’s home. Borrowers apply for a fixed amount of money they need and receive this money as a lump sum if approved. Home equity loans have a fixed interest rate and a fixed schedule of fixed payments for the term of the loan.
The equity in your borrower’s home serves as collateral for a home equity loan, so there must be enough equity in the home for the borrower to qualify. The loan amount is based on several factors, including the combined loan-to-value ratio and whether the borrower has a good credit history. Typically, the amount of a home equity loan can be 80-90% of the appraised value of the property.
The interest rate on a home equity loan is fixed, as are the payments, which means the interest rate does not change over time and the payments are equal throughout the life of the loan. The term of an equity loan can be anywhere from five to 30 years, and the borrower will have predictable monthly payments to make throughout the life of the loan.
Advantages and disadvantages
In terms of benefits, a home equity loan has a fixed amount – which reduces the likelihood of impulse spending – and a fixed monthly payment amount, which makes it easier for the borrower to budget their payments. This type of loan can also be good for those who need a fixed amount of money for something due to the lump sum payment.
The biggest potential downside of a home equity loan is that the borrower can lose their home if they can’t make their payments on time. Additionally, tapping into all of their equity at once can work against them if property values in their area go down. Home equity loans also require refinancing to obtain a lower interest rate, and the borrower cannot withdraw more money in an emergency without taking out another loan.
What is a HELOC?
A HELOC is a revolving line of credit that allows the borrower to withdraw money from the line of credit up to a predefined limit, make payments against that line of credit, and then withdraw cash . Rather than receiving loan proceeds in a lump sum, with a HELOC, the borrower can draw on their line of credit as needed. This line of credit remains open until the end of its term. The amount borrowed can change, which means the borrower’s minimum payments can also change depending on how the line of credit is used.
HELOCs are also secured by the equity in the borrower’s home. Although it shares characteristics with a credit card due to it being a revolving line of credit, a HELOC is secured by this asset, whereas credit cards are unsecured. HELOCs have a variable interest rate, which can go up or down over time. This means that the minimum payment can increase as rates go up. In addition, the rate will depend on the creditworthiness of the borrower and the amount he borrows.
The HELOC terms have two parts – a drawdown period and a redemption period. The drawdown period is the time during which borrowers can withdraw funds. During this period, the borrower will have to make payments, but these tend to be interest only and are therefore usually low. When the drawdown period ends and the borrower enters the repayment period, they can no longer borrow money and their payments now include the principal amount borrowed as well as interest.
Advantages and disadvantages
HELOCs have a few advantages. The borrower can choose how much or how little of their line of credit to use, and that line of credit will be available for emergencies and other variable expenses. Variable interest rates mean that a borrower’s interest rate and payments could potentially drop if their credit improves or market interest rates fall. The borrower pays compound interest only on the amount it draws, not on the total equity available in the HELOC. And HELOCs have a lower interest rate than other options for getting cash, like credit cards or personal loans.
However, since the HELOC is secured by the borrower’s home, the borrower could default and lose their home if they stop making their payments on time. It’s also harder to budget for fluctuating payment amounts, and it’s easy for the borrower to accidentally spend up to their credit limit. Variable interest rates mean that the interest rate and payments could potentially increase if a borrower’s credit deteriorates or market interest rates rise. And the transition from interest-only payments to full principal and interest payments can be difficult for borrowers.
How to choose between a home equity loan and a HELOC
The best way to approach the choice between a home equity loan and a HELOC is to ask the borrower what the purpose of the loan is.
If they know exactly how much they need to borrow and how they want to spend the money, a home equity loan may be a good choice. Many borrowers use home equity loans for big expenses such as a college fund, home improvement, or debt consolidation.
If the borrower is unsure how much to borrow or when to use it, a HELOC may be the best choice. The borrower will have continuous access to cash for a set period of time and can borrow on the line, repay it partially or in full, and borrow that money again later, provided it is still within the HELOC drawdown period. . HELOCs also typically process a little faster than a home equity loan, if the borrower needs the money faster.
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