It's time. The bathroom with wallpaper that pays tribute to Austin Powers has overstayed it's welcome. You're long overdue to make some much-needed improvements and upgrades.
But where does the money come from?
You could charge it on the credit card, but the 14.99% interest rate isn't all that attractive. Realizing you have some equity in your home, you explore your options.
If you are looking to borrow funds from your home’s value, you have two options. You can either choose a home equity loan or a home equity line of credit.
Let's compare the two.
Home Equity Loan
A home equity loan is, in essence, a second mortgage, is an easy personal loan to get, and works much like your first mortgage.
- You will decide on the amount you need and when it is approved, that is the sum you will borrow.
- You then close on the loan, just as you did on your first mortgage.
- You will now receive from the lender a check for the full amount of the loan.
- Just as your first mortgage, you will now make set monthly payments on the loan.
- The loan has a set term and you will make payments each month until the loan has been paid off in full.
- Home equity loans most often carry a fixed interest rate.
- After you have taken out the loan, if you decide later on you need more money, you must apply for a new loan.
There are a couple of advantages of going with a home equity loan, and there is a reason equity loans are the more popular options.
With a home equity loan, you get a fixed interest rate, which is never going to change. You’ll pay the same interest rate, regardless of how long it takes you to pay off the loan.
Not only is the interest rate fixed, but the interest is typically tax deductible.
Home Equity Line Of Credit
A home equity line of credit is a type of loan you open up with a bank or other lender and you can withdraw money from the account as you need it.
Every lending company is different in how they manage home equity line of credit (HELOC). Some companies have restrictions on how much you have to borrow every time and how often you can do that. Other companies require an initial advance.
When you’re approved for a HELOC, they have a set time period which is known as the “draw period.”
After that, you can no longer borrow money against the line of credit and the interest rate will be fixed. After the draw period is over, you may be able to renew the line of credit depending on the company.
- In essence, a home equity line of credit works similar to a credit card in that you use it when you need it. The only difference is that the interest on the line of credit is tax deductible.
- Whenever you need additional funds you can take them, up to the amount you have been approved for. You do not need to apply and close on a new loan each time you need money.
- Payment plans on home equity lines of credit are usually flexible and very often allow interest-only payments for several years, making them easier to handle.
Which loan should you choose?
Really that is based on your particular situation. There are some things to keep in mind when you are trying to make a decision.
First, know that the interest from either loan is currently tax deductible and that both types of loans will use your home as collateral. An assessment will be done in the approval process to determine how much you can borrow.
If you are looking for funds for a specific amount, like to pay off a medical debt, your best bet may be to go with a home equity loan. If however, you are taking out the money to do a remodel to your kitchen a home equity line of credit may be a wiser choice because you never know what additional expenses may come to light.
Additionally, if you are the type of person that has trouble not spending money that is available to them, it may be best to choose the home equity loan so that your spending does not go out of control.
Just like with an equity loan, there are a few pros and cons of choosing an equity line of credit. One of the best benefits of going with a line of credit is you only pay interest compounded on the money you draw, not on the total amount available.
On the other hand, one of the serious disadvantages of lines of credit (or advantages depending on how you look at it) is the interest rate can rise depending on the market and the loan. There is, of course, a chance the interest rate could go down, but more than likely, it will go up before it goes down.
Calculating your Home Equity
When you’re deciding which option is best for you, the first step is determining how much equity you’ve built up in your home.
Calculating your equity is pretty simple. Subtract how much money you owe on your mortgage from the value of your property value. With most lending companies, you’ll be able to borrow up to 85% of the equity in your home.
Before you walk into the lender’s office, you should also calculate your loan-to-value ratio.
Take the amount you owe on your mortgage and divide it by the market value of your home; that’s your loan-to-value (LTV) ratio. If it’s higher, then you are going to have a difficult time getting approved for a loan against your house’s value.
A final thing to keep in mind is you should never borrow more than you can realistically pay back.
Remember, your home could be at risk if you default on either of these loans.