HELOCs, Home Equity Loans, Mortgages, and More
Your home is probably your most valuable asset—so why not use the equity trapped inside to reach your financial goals?
Thanks to the meteoric rise in home prices in 2021, homeowners saw a $2.6 trillion increase in tappable equity—the highest ever recorded. Put another way, the average homeowner now holds claim to over $185,000 in home equity—a sizable lump sum of hard cash that can be used for home improvements, as a downpayment on a second home, or for plenty of other purposes.
To get access to their equity, homeowners can take advantage of real estate-backed financing options. This class of asset-secured financing is an alternative to traditional lending products, and it’s taking the housing market by storm.
With real estate-backed loans, you can borrow money and commit your home or any real estate asset as collateral. Mortgages, home equity loans, and home equity lines of credit are typical examples of real estate-backed financing options. These terms can leave your head spinning, so let’s break them down.
You can borrow against your home equity to fund renovation projects or pay for other large expenses.
What is a home equity line of credit?
A line of credit is a predefined amount of money lent to you by a financial institution (such as a bank or credit union) that you can access on-demand for a set period of time. The maximum amount you can borrow is based on your creditworthiness.
There are two types of lines of credit—secured and unsecured. An unsecured line of credit does not require collateral but carries higher interest rates as they are riskier for lenders. On the other hand, a secured line of credit requires collateral in the form of an asset, like a home, vehicle, or brokerage account.
Because lenders can sell the collateral to recoup their losses in the event a borrower defaults, they consider secured lines of credit to be less risky. For this reason, lines of credit secured by collateral carry lower interest rates than unsecured lines of credit.
Among the most popular secured lines of credit available on the market today is the home equity line of credit (HELOC). But what exactly is a HELOC?
How a HELOC works
A HELOC is a revolving line of credit that allows you to borrow against the untapped equity in your home. Essentially, you’re given a predetermined amount of credit that you can take out and repay anytime so long as you don't exceed the credit limit. As you pay it off, your available credit is replenished.
A HELOC allows you to turn your home equity into cash—quickly and on demand.
As a refresher, equity is your home's market value less the value of all liens against the property—which may include your primary (or if applicable, secondary) mortgage in addition to utility liens, property tax liens, or other municipal liens.
The underlying collateral for the line of credit, in this case, is your home equity—the portion of your home that you actually own. Defaulting may result in foreclosure, meaning you can lose your home if you can’t pay off the balance on your line of credit.
HELOC requirements
While HELOCs come with high flexibility—making them an effective way to fund costly expenses like home renovations, a second home, or tuition payments—there are requirements you’ll need to meet in order to qualify for a line of credit. Particularly, you’ll need:
At least 15% to 20% equity in your home
A credit score of 620 or better
A debt-to-income ratio of 43% or below
At least two years’ history of income
How much can you borrow with a HELOC?
The amount you qualify for is pegged to three things: the equity you have in your home, the lender’s loan to value ratio (LTV), and the balance of your primary mortgage.
To estimate your HELOC credit limit, follow these steps:
First, you’ll need to calculate the maximum amount of borrowable equity = Your home’s value * Lender’s LTV percentage. For example, if your home is worth $1,000,000 and your lender is willing to underwrite a 70% LTV ratio, that means you can borrow up to $700,000, provided your property has no outstanding liens on it.
Next, compute your estimated HELOC limit = The maximum amount of borrowable equity (obtained above) less the sum of the remaining balance on your mortgage and the value of other liens. For instance, if you carry a $500,000 mortgage, your estimated credit limit will be $700,000 - $500,000 = $200,000.
HELOC loan structure, repayment terms, and interest rates
HELOCs come with variable interest rates, which fluctuate based on the market. This means that your interest rate will change based on how an underlying index varies. More specifically, your rate is calculated by adding a margin or markup (called a spread) to the value of this interest rate index. The width of the spread will depend on your credit profile, which includes factors like your credit score, length of credit history, credit utilization ratio, and more. Generally, a higher credit score will allow you to enjoy lower interest rates.
There are two phases to a HELOC: the draw period and the repayment period.
A HELOC has two phases for borrowing and repayment:
The draw period. This period usually lasts for 10 years, during which your credit line is available for use. During the draw period, you’re required to make interest-only payments. However, you can always choose to pay down principal if you wish.
The repayment period. This is usually the 20 years following the draw period. During the repayment period, you can no longer access HELOC funds. You’re required to make fully-amortizing monthly payments that cover both principal and interest.
You now have a bit of an idea about what a home line of credit is. But what makes it different from a home equity loan?
What are home equity loans?
To better understand home equity loans, let's first discuss what loans are in general.
A loan is an amount of money you receive from a financial institution (or another individual) that you pay back with interest at an agreed future date.
Loans have four components. First, there’s the principal—the amount of money you receive from the lender. Next is the interest rate—the cost of the loan. Then there are installment payments—fixed amounts you pay regularly, usually on a monthly cadence. And lastly, the term—the period you have to clear the loan.
All home equity-backed loans or lines of credit that share many similarities with one another.
Like lines of credit, loans are either secured or unsecured. As with secured lines of credit, secured loans (also known as asset-backed loans) are guaranteed by a physical asset like a home or a piece of land. When the loan is backed by a property or any other real estate asset, it is called a real estate-backed loan. One such loan is a home equity loan.
What is a home equity loan, and how does it work? Let's dig deeper!
Home equity loans: features and functions
A home equity loan is a second mortgage against the available equity in your home. Just like with a home equity line of credit, a home equity loan allows you to borrow money using your home equity as collateral. The only difference is that, in this case, you receive a lump sum amount upfront and repay the loan in fixed installments for a preset period.
Depending on the amount of equity you have in your home, you may qualify for a loan that’s larger than what you’d like to borrow. If this happens, you don’t have to take out the largest loan possible. Instead, it’s best to have a budget so that you can borrow exactly what you need. This way, your loan will come with monthly payments you can comfortably service.
HELOCs and home equity loans both use your home equity as collateral, but one is as a line of credit, while the other is a loan.
HELOCs and home equity loans: a quick comparison
Home equity loan and HELOC requirements are typically the same since you borrow against your home equity in both cases.
That said, home equity loans are typically fixed-rate loans, so unlike HELOCs, their interest rates remain constant over the loan period. Loan terms are often five to 30 years—longer than other consumer loans.
However, it’s not all rosy with home equity loans. Like HELOCs, you risk foreclosure if you default on your payments. Also, you’ll have to pay for closing costs, which can range between 2% and 5% of the borrowed amount.
But what if you don't have a home to build equity on? In that case, you’ll need a mortgage to finance your purchase.
What are mortgage loans?
A mortgage is a loan you receive from a financial institution to buy a home when you can’t finance the entire cost of purchasing a house on your own. Widely considered to be the most popular form of “good debt”, mortgages—like HELOCs and home equity loans—are backed by the value of your home. If you default on your mortgage payments, the lender can repossess your property via foreclosure.
How a mortgage loan works
The lender gives you a certain amount of money that you pay back with interest, usually over a term of 15, 20, or 30 years. Thereafter, you make monthly payments which consist of both the principal and interest charged for the loan.
Mortgage loan requirements
Requirements depend on the type of mortgage and lender you decide to work with, but you'll typically need:
A minimum credit score (620+ for conventional, non-agency loans) that confirms a history of responsible payments. Certain agency-backed loans (like the FHA’s 203(b) and 203(k) loans) allow borrowers with lower credit scores to qualify.
Enough money to pay the minimum down payment
Evidence that you earn enough to cover other expenses, including your future monthly loan payments
Sufficient funds to cover mortgage closing costs
While HELOCs, home equity loans, and mortgages are similar in many regards, they feature important differences.
Similarities and differences
A mortgage is a loan, while a HELOC is a line of credit. What differentiates a loan from a line of credit?
You use a loan when you need a lump sum of funds upfront for a specific need—for example, to buy a plot of land. But if you want funds that you can withdraw and pay back at any time to cover unspecified expenses, then a line of credit may be the better choice for you.
In short, HELOCs, home equity loans, and mortgages are all ways of obtaining financing by using your home as collateral. But they contain a few aspects that set them apart. Before exploring their differences, however, let's see what they share in common.
Similarities between HELOCs, home equity loans, and mortgages
To begin with, HELOCs, home equity loans, and mortgages are all secured loans that are backed by the value of your home. This means that if you fall behind on your payments, the lender may sell your property to cover your outstanding debt.
Next, lenders will qualify you by considering your credit score and debt-to-income (DTI) ratio. They'll also use this information to determine the amount you're eligible to borrow. Whether you opt for a HELOC or a home equity loan, your lender will also need assurance that you have the income necessary to service your debt.
Think carefully before borrowing against your home and keep in mind that you may face foreclosure if you default.
HELOCs, home equity loans, and mortgages: the differences
That said, HELOCs, home equity loans, and mortgages also differ in substantial ways. Let’s take a closer look:
A mortgage is taken out for the sole purpose of purchasing a home. This isn't the case with a HELOC or home equity loan, where you borrow against the equity in a home you already own and can use the loan proceeds for a wider number of purposes.
In a mortgage, the loan amount is transferred upon closing to the seller from escrow, after which you (the borrower) receive your home keys. However, with a home equity loan, you receive a lump sum amount that you can use for anything. Meanwhile, a HELOC is issued as a line of credit—you can take out or repay the money any time as long as you stay within your credit limit.
A mortgage has a fixed repayment schedule with regular payments (usually monthly). The vast majority of mortgages are fully amortizing, so the monthly payments include both principal and interest components. In other words, your monthly payments reduce the outstanding balance of the loan. This same characteristic also applies to home equity loans. However, with a HELOC, you make interest-only payments during the draw period and interest plus principal payments in the repayment period.
HELOCs have variable interest rates, while home equity loans have fixed rates. A mortgage, on the other hand, can have a fixed or adjustable interest rate. (However, over 90% of outstanding mortgages are fixed-rate, making this configuration of mortgage by far the most popular choice among borrowers.)
Depending on the type, a mortgage may require a down payment because lenders usually don't fund the entire purchase price. HELOCs and home equity loans don't have such a requirement.
Your home equity is a valuable asset. Keep it lien-free, or pledge it as collateral for a variety of financing products—it’s your choice!
Conclusion
Financing a home purchase or another large expense is often tricky. But real estate-backed financing options offer a solution. Should you go for a HELOC, a home equity loan, or a mortgage?
A mortgage enables you to purchase a home when you can’t afford the full purchase price upfront. Nonetheless, be ready to make a sizable down payment and ongoing monthly payments that cover both the principal and interest.
On the other hand, a home equity loan allows you to afford big life expenses that require lump sum amounts of cash, like buying a second home or paying for school. However, you need at least 15 to 20% of untapped home equity in order to take out this kind of loan.
Meanwhile, a HELOC is flexible and can help you finance expenses when you’re not sure how much they'll cost you—like small home renovation projects, for instance.
Most importantly, make sure to thoroughly research your options before taking on any type of debt. By ensuring that you have a real need for financing and the income, assets, or means to pay it off, you’ll get yourself started on the right foot.
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