Exploring the Different Types of Home Equity Loans

As a homeowner, you likely know that the equity you build in your home over time is an asset. But did you know that equity can also be a source of financing? Home equity loans allow homeowners to leverage their equity to access cash for major expenses, home improvements, debt consolidation, and more.

In this comprehensive guide, we’ll break down the most common types of home equity loans, how they work, and how to decide if tapping into your home’s equity is the right financial move for you

What is Home Equity?

Before diving into the different types of home equity loans let’s quickly cover what home equity is.

Home equity is calculated by taking the current market value of your home and subtracting any outstanding mortgage debt. For example:

• Your home is worth $500,000
• You owe $200,000 on your mortgage
• Your home equity is $300,000 ($500,000 – $200,000)

The more equity you have, the more financing options you potentially have access to. As you make mortgage payments over the years, you build equity and increase the value of your biggest asset – your home.

An Overview of Home Equity Loans

Home equity loans allow you to borrow against the equity in your home. The loan is secured by your home, meaning your home acts as collateral on the debt.

Here are some key things to know:

• Interest rates are typically lower than other financing options like personal loans or credit cards because your home secures the debt.
• You can borrow up to 85% of your total home equity in some cases.
• Monthly payments on home equity debt are fixed.
• If you default, the lender can foreclose on your home.

While home equity loans come with risks, they can provide homeowners with an affordable way to access funds for major one-time costs or an ongoing project. Let’s look at the most common types of home equity loans.

Fixed-Rate Home Equity Loans

A fixed-rate home equity loan provides you with a single lump sum payment upfront. You’ll pay back the loan over a fixed period of time, usually between 10 to 30 years.

Here are some key features:

• You receive the full loan amount upfront in one disbursement.
• The interest rate stays the same for the entire loan term.
• Your monthly principal and interest payments don’t change.
• Loan terms are generally between 10 to 30 years.
• You can borrow up to 85% of your home’s value minus your mortgage debt.

Fixed-rate home equity loans work well if you have a large, one-time expense like a home remodel or wedding costs. You get the funds upfront in a lump sum.

Home Equity Lines of Credit (HELOCs)

A home equity line of credit (HELOC) works more like a credit card than a traditional loan. A lender approves you for a revolving credit line up to a certain limit based on your home equity.

Here’s how HELOCs work:

• You can access funds as you need them rather than getting a lump sum.
• Interest rates are variable, meaning they fluctuate over time.
• You only pay interest on what you use, not the full credit limit.
• Draw periods last for 10 years usually. After that you enter the repayment period.
• Loan terms range from 10 to 30 years.

HELOCs are a flexible option if you have ongoing projects and want to access funds over time. You only tap the credit line as needed.

Cash-Out Refinancing

With a cash-out refinance, you refinance your existing mortgage for more than what you currently owe. You get the difference in cash.

Here’s an example:

• Your home is worth $400,000
• You owe $175,000 on your current mortgage
• You refinance for $200,000 and get $25,000 cash back

Benefits of a cash-out refinance include:

• Access to cash for any purpose
• Potential to get a lower mortgage rate
• Opportunity to change your loan term

The main catch is that refinancing comes with upfront costs. Make sure to weigh the costs versus potential savings.

How to Choose the Right Home Equity Loan

When deciding which type of home equity loan works for your situation, here are some key considerations:

Your purpose for the funds

Do you need a lump sum for a one-time expense like a remodeling project? Or will you need access to funds over time for something like a small business launch? Your purpose can help guide which loan type fits best.

Current mortgage rates

If you want to tap equity but have a high existing mortgage rate, a cash-out refinance could allow you to access cash while securing a lower rate. Compare current market rates versus your existing rate.

Your current financial situation

Assess your current income, debt obligations, credit score and expenses. Make sure you can manage another monthly loan payment comfortably.

Foreclosure risks

While rare, understand that defaulting on a home equity loan could put your home at risk of foreclosure. Only borrow what you can realistically manage.

Pros and Cons of Home Equity Loans

Before applying for a home equity loan, consider both the benefits and potential drawbacks:

Pros

• Access to funds at lower rates than other financing options
• Opportunity to consolidate higher interest debt
• Potentially tax deductible (consult a tax pro)
• Build financial flexibility and borrowing power

Cons

• Second loan on your home means added debt obligations
• Variable rates on HELOCs could increase over time
• Closing costs and fees
• Risk of foreclosure if payments are missed

For many homeowners, the pros outweigh the cons. But make sure you go in with eyes wide open.

Home Equity Loan Requirements

To qualify for a home equity loan, lenders will evaluate:

• Your credit score – Minimum scores vary by lender but 600+ is typical
• Your total debt-to-income ratio – Below 50% is ideal
• Your loan-to-value ratio – The amount borrowed vs. total home value
• Your home value – Enough equity is required

Requirements vary, so discuss your specific qualifications with lenders. An online lender like Rocket Mortgage lets you check rates and your estimated approval amounts online.

Home Equity Loan Costs

When budgeting for a home equity loan, be prepared for these common costs:

• Origination fee – Upfront fee charged by the lender, often 1% to 6% of the loan amount
• Third-party fees – Appraisal, title search, document prep fees
• Closing costs – Average $3,000 to $4,000
• Early repayment penalties – Some loans charge fees if paid off early

Always ask lenders to detail all fees and closing costs for accurate budgeting.

Alternatives to Home Equity Loans

If you’ve weighed the pros and cons and decided a home equity loan isn’t the right fit, here are a few alternatives to consider:

• 401(k) or Retirement Account Loan – Borrow against your own savings.
• Personal Loan – Unsecured loan with fixed rates.
• Credit Card – Revolving credit line. High rates but easy to qualify.
• Family Loan – Borrow from a family member.
• Home Improvement Grant – Free grant money, if you qualify.

Each option has advantages and downsides to weigh. Make sure to explore all your financing options before moving forward.

Is a Home Equity Loan Right for You?

Tapping into home equity can provide homeowners with an affordable way to finance major expenses, consolidate debt, and more. But added debt obligations come with risks that must be carefully considered.

If you move forward, be conservative with loan amounts and realistic about repayment. With proper budgeting and discipline, a home equity loan can offer financial flexibility and value.