By Lynnette Khalfani-Cox, The Money Coach®
As a homeowner, if you’ve build up equity in your property, and you need to tap that equity for any reason, you may be wondering: which is better—a HELOC or a home equity loan?
Both financial offerings give you a way to convert the equity in your home into usable cash, yet HELOCs and home equity loans differ in key ways.
What Exactly is a HELOC and How Does it Work?
A home equity line of credit, better known as a HELOC, is a type of mortgage loan that lets you take money out as you need it, during a so-called “draw period,” which is determined by your lender. You can think about a HELOC as akin to a credit card in two ways. First, HELOCs and credit cards both usually have variable interest rates. With both products, once you pay the amount you’ve borrowed, you can borrow additional funds. Also, HELOC interest rates are significantly lower than credit card rates because they are secured loans, backed by real estate. So if you don’t pay what you owe on a HELOC, and go into default, the property against which you’ve borrowed could be seized by your lender.
Assuming your HELOC remains in good standing, you could have a draw period that commonly lasts for between five and 10 years. After that draw period ends, you begin a “repayment period,” which typically runs for anywhere between 10 and 20 years.
You can use the proceeds from your HELOC for nearly any purpose such as making home improvements. Many borrowers choose a HELOC if they know they will have large expenditures over time, such as paying for a child’s college tuition over four or more years. Some people also like having a HELOC simply as a standby line of credit–just to be prepared for unexpected circumstances. And fortunately, with a HELOC, you only pay interest on the amount of the credit line you’ve used.
What is a Home Equity Loan?
Whereas a HELOC provides you with access to funds over time, a home equity loan gives you one lump sum of money, much like a personal loan. So a home equity loan often makes sense if you know you have a single purpose—perhaps a home remodeling project—that requires you to pay an expense all at once.
With a home equity loan, you begin immediately repaying interest on the full amount borrowed, your interest rate is typically fixed, and your repayment amount is the same each month. In contrast to a HELOC, you can’t keep taking out money once you’ve paid back the principal on a home equity loan. But just like a home equity line of credit, the amount of your home equity loan will be determined based on the value of your home and your existing mortgage balances, among other factors.
Qualifying for a HELOC or Home Equity Loan
To qualify for a HELOC or a home equity loan, lenders check your credit scores and assess your debt-to-income ratio, or DTI, to figure out how much of your income is already going to satisfy other monthly debts.
Generally speaking, the lower your DTI, the greater chance you have to qualify for a home equity loan or line of credit. Lender guidelines differ from one financial institution to the next. But most credit unions, banks and other mortgage lenders want your debts to fall somewhere between 36% and 45% of your income. As a rule of thumb, to qualify for a HELOC or home equity loan, SchoolsFirst FCU advises that your DTI should typically be less than 43%. However, there may be other factors that will offset a slightly higher DTI. Your loan consultant can discuss your specific options.
The amount of equity you have in your home obviously matters too – which is why mortgage lenders will also assess your combined loan-to-value ratio, or CLTV.
The combined loan-to-value is the amount you owe on your all mortgages (including the home equity loan or line of credit) divided by your home’s current market value, as determined by a recent appraisal.
Again, you have a better chance of qualifying for a home loan with a lower LTV.
Typically, LTV ratios need to be at or below 90% (and sometimes 80%) to qualify for a home equity line of credit. Lenders like to have a cushion of about 10% to 20% equity in the home in the event payments aren’t made and they need to foreclose.
If you want to learn more about your home equity options, or would like to apply for a home equity loan or line of credit1, contact SchoolsFirst Federal Credit Union online or contact a real estate loan consultant at 800- 800-462-8328 ext. 8288.
Federally Insured by NCUA.
- All loans are subject to approval.
Extra Credit provides general information to help improve our Member’s financial lives. Every situation is different, so please contact us for guidance on your specific needs. The advice provided in Extra Credit is not intended to serve as a substitute for speaking to a loan representative, financial advisor, or GreenPath Financial Wellness counselor who can help tailor a solution for you.
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