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If you need extra cash for a major purchase or personal expenses, then you may start exploring loan options. You might come across options that include credit cards, personal loans and home equity loans or lines of credit. Each loan type has its pros and cons, so it’s important to know which loan works best for your situation.
For those looking to borrow a larger amount of money with a reasonable interest rate, a secured loan is often a top choice. We’ll take a look at two popular secured loan options: a home equity loan and a home equity line of credit (HELOC), along with the requirements to obtain them.
What are HELOCs and home equity loans?
Both HELOCs and home equity loans use your home’s equity as collateral for the loan. Your home equity is calculated by subtracting your mortgage balance from the appraised value of your home. Banks can offer lower interest rates on these loans than other credit products because your home is the security for the loan.
Although HELOCs and home equity loans are similar in the sense that they are both secured by your home’s equity, they do have some differences. The main difference is how you repay the loan and how the interest factors into your repayment, which we will cover in more detail below.
HELOCs and home equity loans can be great options for those who need extra cash to fund large purchases, home improvement projects, education expenses or even additional real estate investments.
Because of the lower interest rates on these loans, many borrowers use them to consolidate high-interest debt as well. Depending on how much equity you have in your home, your home equity loan or line of credit could be much more than you’d get with a credit card or even a personal loan.
Not sure whether you need a HELOC or a home equity loan? Here’s more information about the difference between the two.
Home equity lines of credit (HELOCs)
A home equity line of credit uses your home’s equity to secure a line of credit which is similar to how a credit card works. HELOCs can also come with variable interest rates and repayment schedules, unlike a fixed-rate mortgage.
Also, like a credit card, you’ll only make payments and owe interest on the outstanding balance. For instance, you may have a $75,000 home equity line of credit. However, if you only have a $5,000 balance, this is the number that will determine your monthly payment, including any interest you’ll pay.
You can access funds as you need them from your HELOC during what is called a draw period. During this period, you will make interest-only payments until the end of the term, at which point the remaining balance must be repaid or refinanced.
The typical draw period for HELOCs is 10-20 years but may vary depending on your lender’s guidelines. After the draw period ends, you’ll enter into a repayment phase where you must begin making principal and interest payments until the loan is paid in full.
You should also know that most lenders have an introductory rate during the draw period that may change after it expires. Make sure you are clear on all the terms related to your HELOC before moving forward.
Home equity loan
A home equity loan is less like a credit card (or line of credit) and more like an installment loan. Unlike a HELOC, with a home equity loan you’ll receive the full amount of the loan at once and make fixed monthly payments towards the principal balance over a set period of time. In addition to a fixed monthly payment, your interest rate is also fixed at the outset of the loan.
There are limits on how much you can borrow with this type of loan, and it will depend on the amount of equity you have in your home along with your creditworthiness as a borrower. We’ll cover this below in more detail.
How to qualify for a home equity loan or HELOC
Like most loans, lenders will qualify you based on your financial profile. The main requirement for these loans is to be a homeowner, but lenders look at other qualifications when underwriting your loan.
Here’s how to qualify for a home equity loan or HELOC.
Own a home
Not only do you have to own a home, but you’ve got to have enough equity in your home to qualify for either one of these loans. For instance, if your mortgage balance is $295,000 and the appraised value of your home is $300,000, you probably won’t be approved for a home equity loan or line of credit because most lenders won’t lend such a small amount of money. Plus, it wouldn’t make much sense to borrow such a small amount as a home equity loan due to the closing costs and fees associated with these types of loans.
Be a creditworthy borrower
Although your home’s equity secures these loans, you must still meet eligibility criteria based on your credit profile. If you’ve got a history of making late payments or many accounts in collections, this could indicate that you are not very good at managing your debt obligations. Lenders would perceive you as a credit risk and possibly decline your loan application if you have a low credit score.
In addition to having a good credit score, you should have a debt-to-income (DTI) ratio that meets your lender's requirements. If you have too many monthly debt obligations against your monthly income, your loan approval odds will be lower.
Have enough steady income to cover your debt payments
Finally, your lender will ensure that you have a consistent source of income that will cover both your existing debt obligations and the new debt you’ll be responsible for with your home equity loan. If you don’t have enough consistent income to satisfy lenders' eligibility criteria, your loan may not be approved despite having a home with enough equity to secure the loan.
How much can you borrow?
How much your lender will give you based on your home’s equity depends on a few things:
- The appraised value of your home.
- Your current loan-to-value (LTV) and prospective combined loan-to-value (CLTV).
- The balance on your mortgage.
- Your credit score and debt-to-income ratio.
Before you apply for a home equity loan or line of credit, you should know your current loan-to-value limit (LTV), which is how much equity you’ve accumulated in your property. Simply take the loan balance and divide it by the appraised value of your home.
A home that appraises for $400,000 with a $300,000 mortgage balance would have an LTV of 75%. Lenders generally don’t want you to exceed a combined loan-to-value (CLTV) of 80%. In the example above, if you borrow $20,000 against your home, your CLTV would be right at 80%.
In some cases, your lender may have a minimum loan amount or even a maximum loan amount. It’s important to compare rates and loan estimates among different lenders to find the loan amount and terms that work best for your financial circumstances.
Alternatives to home equity loans and lines of credit
If, for some reason, you don’t qualify for either of these loans or you simply don’t want one, there are plenty of loan alternatives you can explore. Here are a few to start.
A personal loan is typically unsecured and allows you to borrow a lump sum at a fixed interest rate. This means your monthly payment will be consistent with a set repayment term, usually between two to five years.
Because these loans are unsecured, meaning they don’t require any collateral, the terms are not always as favorable. For instance, if you don’t have excellent credit or higher income, your interest rate could be higher for a lower loan amount and a shorter repayment term.
A personal loan could work for large purchases, home improvements, medical bills, or even debt consolidation.
Personal line of credit
A personal line of credit combines features of both a personal loan and a credit card. Like a personal loan, it’s unsecured. Like a credit card, there’s a credit limit and you’ll only owe interest and make payments on the outstanding balance. This type of loan also requires a good credit profile and consistent income.
However, you may get a slightly higher credit limit than you would with a credit card. This kind of loan might work if you have recurring expenses for a small business that requires inventory or similar ongoing expenses.
Zero percent intro APR credit cards
If you’ve got good to excellent credit, you may be eligible for a promotional offer called a 0% APR credit card promotional offer. This means you can carry a balance on the credit card for a certain amount of time without paying any interest. Read the fine print to learn if the promotional APR covers purchases, balance transfers or both.
A 0% APR card can be ideal if you want to consolidate smaller amounts of high-interest debt. If you can pay down the balance before the promotional APR period ends, you could save hundreds or even thousands of dollars on interest.
At the end of the day
Borrowing money can be intimidating and confusing if you aren’t sure about your options. However, with some research and comparison shopping, you should be able to find a loan that works well for your needs. Whether you borrow against your home’s equity, use a credit card or get a personal loan, be sure to weigh the pros and cons of each option to make the best decision possible.
Frequently asked questions (FAQs)
Are HELOCs hard to qualify for?
The main requirement to get a HELOC is to own a home with enough equity to qualify for a loan. Additionally, you should meet eligibility requirements around income, credit score and outstanding debt obligations.
Can you get denied for a home equity loan?
Yes. Like any loan, you’ll have to meet eligibility requirements around income, credit score and outstanding debt obligations. These requirements vary from lender to lender.
Can I get a HELOC and a home loan at the same time?
Yes. Although having multiple loans against your home is not common, it’s not impossible or illegal. As long as you meet lender eligibility requirements regarding LTV, income, credit score and outstanding debt obligations, you can get as many home equity loans or lines of credit that you qualify for.
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