Existing homeowners are sitting on a piggy bank.
The median U.S. home listing price was $449,000 in July 2022, according to data from Realtor.com. This 16.6% year-over-year increase is making it tough for prospective homebuyers trying to enter the market.
Homeowners, however, got an average $64,000 equity increase by the end of the first quarter on 2022, according to the most recent Homeowner Equity Insights report by housing data firm CoreLogic.
While the names are similar, home equity loans and HELOCs are different financial products. Even though they both use your home as collateral, deciding between the two options depends on how you plan to use the funds.
Before you take out a loan against your home, it’s important to understand some of the requirement, benefits, and potential drawbacks.
What Is a Home Equity Loan and a Home Equity Line of Credit (HELOC)?
Even though both are similar, there are some differences. Do keep in mind that both can leave you at risk of foreclosure if you fail to pay back your lender.
Home equity loans are distributed as a single lump sum that you pay back to the lender with interest in fixed monthly payments. Think of it like a second mortgage on your home. Home equity loans have fixed interest rates, which means the rate doesn’t change. They can also be tax-deductible, depending on how you use them.
A HELOC acts like a credit card, so you can tap into the funds whenever needed. As you pay the balance back, the available balance is replenished. There is a draw period where you can withdraw funds, followed by a repayment period where you no longer have access to the funds.
Requirements to Borrow From Home Equity
To borrow from your home’s equity, you need to have enough equity in your home. To qualify, you should have already paid down at least 15% to 20% of your home’s value — so, for example, $100,000 if your home is valued at $500,000. Part of this process will be the lender appraising your home’s value, which comes at your expense.
“Equity is the difference between the home’s appraised value and the total mortgage balance,” says Samuel Eberts, junior partner and financial advisor with Dugan Brown, a retirement firm.
Lenders will also take a look at your debt-to-income ratio (DTI), which is calculated by dividing total monthly debt payments by gross monthly income. Qualifying DTIs vary from lender to lender but typically it’s less than 36%, meaning your debt should be less than 36% of your gross monthly income. Other lenders go as high as 50%. Lenders will also be looking at credit history. Having a credit score above 700 will be good enough to be accepted; a credit score in the mid-600s may be accepted. Having a good credit score is important because it’ll help you land a better interest rate.
To prove that you have income, be ready to supply pay stubs and possibly W2s and tax returns.
Should You Get a Home Equity Loan or HELOC?
Read more: How to Get a HELOC – Zillow
Before making the decision between a home equity loan and a HELOC, it’s important to understand how much money you’ll need and for how long.
“If you are not sure how much money you need for what you are setting out to accomplish, taking out the line of credit [HELOC] will provide more flexibility than the loan. The downside to this is that interest rates may increase and you could get stuck paying rates while still having to make your regular mortgage payment simultaneously,” says Eberts.
Whichever decision you make, make the payments. Since your home is used as collateral, you don’t want to run the risk of foreclosure.
Alternatives to Home Equity Loans and HELOCs
If the idea of using your house as collateral for a loan doesn’t appeal to you, there are other ways to achieve your financial goals. Here are some other options:
- Cash-out refinance: A cash-out refinance is when you refinance your primary mortgage for more than you owe and receive the difference in a lump sum. “If you are eligible for lower rates with a cash-out finance plan, it can be a great idea,” says Akhil Kumar, vice president and CCO of Arch Global Advisors, a financial advisory firm. Now that rates have risen above their historically low rates of the past two years, that might not make as much sense.
- Balance transfer credit card: If you have good credit, you could qualify for a 0% APR balance transfer card. It offers you the ability to transfer over any debt to a 0% interest card, sometimes for 18 months. This gives you the ability to make a big purchase and pay it off over time with zero interest. Just be sure to pay it off by the end of the promotional period or you’ll pay interest on the remaining balance.
- Credit Counseling: If you have trouble staying on budget and paying your debt, or if you’ve got a financial goal you’d like to build toward, you can contact a non-profit credit counseling agency to help. You’ll receive education-based tools to help manage your money. It empowers you to take control of your own financial health and help you make better decisions in the future. Find a credit counselor by searching the U.S. Trustee Program database here.