Building equity is a major draw of owning a home. When you sell, you get to keep most of the principal payments you’ve made, plus any value the home gained over time. The downside? None of that equity is accessible until you sell.
Home equity lines of credit (HELOCs) and equity loans come in handy by allowing you to borrow against the value of your home while you still live there. Essentially, “you can access your net worth and turn it into liquidity,” said Jeff Checko, a real estate broker with The Ashton Real Estate Group in Nashville, Tennessee.
These can be a good way to finance a major home project, pay off high-interest debt or handle a financial emergency. Understanding the differences and weighing the pros and cons of each will help you decide which is right for you.
How to calculate home equity
Each lender has a different formula to determine how much you can borrow. But to qualify for either a home equity loan or line of credit, the lender first checks your loan-to-value ratio, which is the amount of equity you have in the home. Then, the lender will set your borrowing amount as a percentage of the equity you own. Here’s how it works:
Step 1: Determine your LTV ratio.
Say your home is worth $200,000 and you owe $130,000 on your mortgage. Divide those two numbers to get your LTV ratio:
$130,000 / $200,000 = 0.65 or 65% LTV
Lenders will generally approve loans with a maximum loan-to-value ratio of around 80% or less. In this example, the LTV falls within that range, which means you may qualify for a loan or line of credit.
Step 2: Calculate how much you may borrow.
Subtract your balance from the home’s value to get the amount of equity you own:
$200,000 - $130,000 = $70,000
Lenders typically allow you to borrow up to 85% of your available equity, depending on the lender and your credit and income. In this example, you would be able to borrow up to $59,500:
$70,000 x 0.85 = $59,500
What is a home equity loan?
A home equity loan is a lump sum of money you can borrow from a bank, using your home to secure the loan. You’ll pay back the loan over the course of a fixed term, usually with a fixed interest rate.
To get a home equity loan, borrowers typically need a minimum credit score between 620 and 680, a loan-to-value ratio of about 80% or less (which includes your existing mortgage) and a source of income.
Home equity loan pros and cons
- Tax deductions: You may be able to deduct the interest paid on home equity loans if you use the funds only for home improvements. However, “with the new tax laws, itemizing a tax return may no longer be a benefit versus just taking the standard tax deduction,” said Mark Zihmer, vice president of mortgage lending at CrossCountry Mortgage Inc. “It will depend on the individual taxpayer and how many deductions they can claim.” Check with a tax professional to figure out your situation.
- Fixed payments: Home equity loans offer a fixed interest rate with predictable monthly payments.
- Favorable terms: Because home equity loans are secured, borrowers may get a lower interest rate and a longer payback term than with unsecured loans, such as a personal loan.
- Extra costs: The lender may charge upfront fees and costs, which adds to the total cost you’ll repay over time.
- You lose equity: Because your loan amount is subtracted from the home equity you’ve grown, you’ll need to rebuild it.
- Risk of foreclosure: If you can’t pay back the home equity loan, the lender could foreclose on your home.
What is a home equity line of credit?
A HELOC is a preset amount of money that a bank has agreed to lend you, usually with a variable interest rate. You’ll only draw from the line of credit when you need the funds and pay interest on whatever you take out. Like a home equity loan, you’ll use the home to secure the line of credit.
The lender will base the HELOC amount on your creditworthiness, the amount of your outstanding debt and the equity in your home. Typically, lenders limit the amount you can borrow up to 85% of your available equity.
The lender may also impose a minimum or maximum withdrawal requirement and a time frame in which you can draw from the funds. Usually, you’ll be able to take out the money using checks, credit cards or both.
Home equity line of credit pros and cons
- Tax deductions: Like a home equity loan, you may be able to deduct the interest paid on a line of credit as long as the funds are used to pay for home improvements.
- On-demand money: The line of credit is available whenever you need it. “It’s just peace of mind, knowing you’ve got X amount of dollars there and accessible to you,” Checko said. You can also pay back the line of credit and then use the funds again, like with a credit card.
- Interest only on what you need: You’ll only pay interest on the amount you draw, not the total value of the line of credit.
- Unpredictable payments: The interest rate may change between the time the bank approves the line of credit and when you actually draw from it.
- Extra fees: The lender may charge fees such as an application fee, title search, appraisal, attorneys’ fees and points, and ongoing fees throughout the life of the line of credit. These expenses will add to the cost of the money you borrowed.
- You lose equity: Like with a home equity loan, you’ll lose equity as soon as you borrow against the home—and risk foreclosure if you can’t pay back the money.
HELOC vs home equity loan: Which is right for me?
Because the interest rates between the two types of loans are about the same, and the credit requirements are roughly the same, too, deciding between a HELOC versus a home equity loan comes down to how you want to use the funds.
The home equity loan is a good fit for people who need the money upfront and know how much they need to spend. They’re also good for anyone who likes the safety of knowing their monthly payment upfront and plan to pay off what they owe over a long period.
A HELOC could be an alternative if you don’t need the money immediately and you have ongoing costs. The line of credit allows you to take out only what you need, pay it back and repeat.
Use your equity wisely
Deciding to borrow against your home in the first place shouldn’t be taken lightly. “Home equity should be the backbone of your financial security for your future retirement,” Checko said. If you can’t pay back the money you borrowed, the bank may foreclose on your home—wiping out your equity entirely.
If you prefer not to borrow against your equity, you can check out alternatives such as personal loans or credit cards with a 0% intro APR. But if you decide to go with a home equity loan or line of credit, they may provide lower interest rates, longer payback terms and potential tax benefits.
“People have this connotation that when you’re accessing equity in your home, it’s a no-no,” Checko said. “But there are a lot of people who do very well leveraging their equity.”