Should You Take HELOC or Home Equity Loans?

Either one of these has its own pros and cons. I personally prefer HELOC (Home Equity Line of Credit) for a number of reasons. In this blog post, let’s talk about the similarities and differences between the two.

First of, HELOC and Home Equity Loans are drawn from the equity of your home. Typically, lenders will allow you to pull your equity out only on Primary residences. There is only a small percentage of lenders who will let you pull equity out of investment properties. And this is because they view investment properties have a much higher default risk.

Homeowners who pull equity out of their primary home, they will be more likely to put every effort to pay it back so that they will not lose their home. On the contrary, they will probably a lot careless about investment properties. Similar rules apply when you apply for a mortgage. Therefore, mortgage rates on investment properties are higher than if it was for primary residence.

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So, let’s go back to the HELOC and Home Equity Loans comparison. In summary, Home Equity Loans allows you to pull equity out of your home at a fixed interest rate. Think of it as you are doing a cash-out refinance. If your home value has increased, you can refinance and take out your equity. The HELOC has variable interest rates and it’s not the same as cash-out refinance.

HELOC (Home Equity Line Of Credit)

Pros:

  • Acts like a credit card. Use only what you need.
  • Pay Interest ONLY on the amount that you use.
  • Allows Interest Only payments.
  • Lenders typically give 10 years of drawing period with very minimal annual fee.
  • Access the equity money at anytime within the 10 year drawing period

Cons:

  • Adjustable/Variable interest rates – Keep in mind, this could be a deal breaker for most people. Tip: look for lender who offer an Interest Rate Cap. This will help you estimate how much interest you will be paying in the worst case scenario (highest rate possible allowed by your HELOC agreement).
  • After drawing period ends, any balance used will be amortized into 20 years mortgage payment (your lender rules may differ on this).

Home Equity Loans

Pros:

  • Fixed Interest rate.
  • You will get a fixed monthly payment for a set period.

Cons:

  • You must take your equity at LUMP SUM and Upfront.
  • Interest is charged starting Day 1.

Based on the comparison above, I like HELOC better because of the flexibility. I don’t have to take the money on Day 1 and start paying interest. This feature is great if you still debating on what the money will be used for. Let’s say if you plan to use it to buy a second home, you do not have to pull the money from the HELOC account until the day you close the escrow. So, during the whole process of buying a home, you are paying $0 interest.

Home Equity Loans does not have that kind of flexibility. However, it might be a better deal for you if you know right of the bat what the money will be used for. If your timing is right, putting your Home Equity Loan money to use since Day 1, is definitely better since the interest is fixed and most likely be lower than a HELOC.

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How To Calculate How Much Home Equity Do You Have?

Depending on your credit history, lenders typically allow you to have a Loan To Value (LTV) of 80% (and if you have such an incredible credit, this may go 85%). For the purpose of this calculation, let’s use the 80% LTV.

The first thing you need to do is to find out what your home value is. You can check on Zillow, Trulia, or Other real estate website to get an estimate. Keep in mind, your lender will hire an appraisal to get a final value before approving your loan. Next, find out how much mortgage balance left in your home.

For this calculation, let’s just say your home value is $400,000 and you have a mortgage balance of $200,000. Based on the 80% LTV, the calculation is below:

$400,000 x 80% = $320,000

$320,000 – $200,000 (mortgage balance) = $120,000 Equity allowed to be withdrawn.

It’s a simple calculation and the key is in the LTV. The higher the LTV, the higher the amount of equity you can withdraw. Now, you might think that based on the above numbers, your equity should be $400,000 – $200,000 = $200,000. This is correct, but since you are withdrawing your equity as a loan, lenders will want you to still have the “skin in the game”. Withdrawing the whole $200,000 equity will put the 100% risk at the lenders’ court.

So, which one would you prefer? I would suggest to look at your needs. Is it urgent? Or do you want to just have an access to the money at anytime?

Remember, either way you go, your home is the collateral on both loans. If you don’t pay it back, you could lose your home. Be wise with the money!

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