What is a Home Equity Loan?

Home Equity
September 22, 2023
 What is a Home Equity Loan?

One sage piece of advice often given to homeowners is to “expect the unexpected.” While this may also sound like something a magician-for-hire might say, it’s true — homeownership can bring with it more than a few unexpected costs. These can come in the form of air conditioners that need replacing (somehow always during the dead of summer), roofs whose shingles could use sprucing up, or extensive damage from termites, mold, water, or all three. 

Though unexpected, these expenses don’t always have to be unpleasant! Putting in a pool can help breathe new life into a home, as can investing in lush landscaping (koi pond, anyone?) or a media room. Unwanted or otherwise, these expenses won’t pay for themselves — and will likely eat into even the most robust of savings accounts. So, how do these improvements (unwanted or otherwise) get paid for when the bill comes due? When facing the decision of how to get the equity out of your home - a home equity loan or a home equity line of credit (HELOC) can end up saving the day.

When expecting the unexpected isn’t enough, home equity loans and a home equity credit line can be of great use to homeowners, but there are unique pros and cons of each which are worth investigating. Keep reading for an in-depth analysis of home equity loans, HELOCs, and the benefits (and limitations) of both — as well as how the perks of home equity loans stack up to refinancing options. 

What Is A Home Equity Loan?

A home equity loan (or a second mortgage) is a financial tool that allows a homeowner to leverage the equity in their home to borrow money from a lender. As an example, let’s say that a home is valued at $400,000, and the homeowner owes half of that on the home. This would mean that the amount available for a home equity loan is a hefty $200,000. This loan amount is then paid out in full, allowing the homeowner to pay back the balance of the loan through monthly installments. 

One of the most significant advantages of a home equity loan over a private loan type — or maxing out a credit card or two — is that the interest rates and monthly payments affiliated with home equity loans are always a fixed interest rate, and often lower. This removes any uncertainty from the equation, ensuring that the homeowner knows the exact impact that a home equity loan will have on their financial future.  

While home equity loans are generally used to cover costs affiliated with a home, like the above renovations, repairs, or koi pond additions, these loans have a number of different applications — amounting to what is a home equity loan’s greatest advantage: its flexibility. Practical uses like paying for college tuition while avoiding unscrupulous loan providers or allocating the equity toward investments are also common, but the limitations of these versatile loans are near endless. Vacations, weddings, and new vehicles can all be paid for using a home equity loan. However, whether or not taking out a home equity loan to cover these things will be up to you.  

What Is A Home Equity Line Of Credit (HELOC)?

A home equity line of credit is a sort of hybrid between a credit card and a home equity loan. If you need it even simpler, a home equity loan of credit allows homeowners to take loans out against their equity as often as they want — in any increments they need — so long as it doesn’t exceed their available equity. Whereas a home equity loan allows homeowners to leverage their equity and take out a loan in a lump sum, a home equity line of credit’s key attribute is that homeowners can continue to take funds out as they need without accruing interest on any untapped equity. 

Though a home equity loan and a home equity line of credit share some commonalities, they can each have drastically different impacts on homeowners and their financial futures — which we will explore, in detail, below. 

How Home Equity Loans and HELOCs Compare

Home equity loans and home equity lines of credit both allow homeowners to take out loans using their home equity, but the similarities between the two effectively end there. Perhaps the biggest differences between the two lie in their interest rates and monthly payments. What is a home equity loan’s biggest advantage over a home equity line of credit is that home equity loans tout both a fixed interest rates and a fixed payments, whereas a home equity line of credit offers neither. This puts homeowners in an insecure position when it comes time for repayment should they elect to employ a home equity line of credit over a home equity loan. 

While a home equity line of credit may allow a homeowner to take out equity only as they need it, changing market conditions could limit access to that loan type altogether. The old expression “a bird in the hand is worth two in the bush” rings true here, and homeowners may find the guaranteed equity of a home equity loan to be superior to that of a home equity line of credit.

This isn’t to say that a home equity line of credit is without its advantages over a home equity loan. In a pinch — when paying off credit cards or bridging the gap between jobs is more important than installing a pool — a home equity line of credit may be the more attractive option than a home equity loan. Further, a lump sum home equity loan may actually encourage overspending, while a home equity line of credit may help homeowners rein their finances in a bit better. 

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Who Is Eligible For A Home Equity Loan? 

Although home equity loans and home equity lines of credit may be “easy” ways for homeowners to access funds tied up in a home, the eligibility process is not always so simple. In order to be eligible for a home equity loan1 from an equal housing lender, homeowners must have at least 15 to 20% equity in their home, have a credit score of 620 or higher, and possess a debt-to-income ratio which is at or below 43%. If you’re wondering about how to build equity in a home, make sure to read up on the topic to ensure that you know everything there is to know about the process. Borrowers will also have to show upwards of two years of employment history in order to be eligible for a home equity loan. 

Eligibility for a home equity line of credit is barred by these same requirements, though different lenders may draw different lines in the sand when it comes to credit scores and home equity. Homeowners who do not meet these criteria are not entirely out of luck, however — and some financial institutions will trade high-risk borrowers elevated interest rates in exchange for loan eligibility.  

Understanding the Two Phases of a HELOC

Though a home equity line of credit can be a great option for homeowners looking to tap into their home equity, they can also trap borrowers in repayment limbo — as was the case for those who took out HELOCs to make ends meet in 2008. The way that a home equity line of credit can do this is through its two very distinct phases. 

Phase One of a Home Equity Line of Credit

The first phase of a home equity line of credit, also known as the draw period, consists of the time between when the line of credit is taken out and when personal loan repayment begins. This is typically a 10-year span, during which borrowers are only required to make interest payments.2 This phase can be a sort of “honeymoon period,” as borrowers enjoy reduced payments while reaping all the benefits of the loan. 

Phase Two of a Home Equity Line of Credit

While a draw period can be extended, repayment typically begins after the 10-year mark — and can last upwards of 20. On top of the interest paid during the draw period, the repayment period sees borrowers begin to make payments on the principal of the loan term. Homeowners who overextended themselves during the draw period may find themselves saddled with unmanageable fixed payment rates now that they are on the hook for both the principal and interest, and this is where borrowers can commonly feel that they have been caught in the HELOC “trap.” 

If you’re looking to avoid the shock that can result from wild payment fluctuation — and trust yourself to take out a single home equity loan for a set amount — this dual-phase system can make a home equity loan the more attractive automatic payment option compared to a home equity line of credit. 

Home Equity Loans vs. Refinancing

Home equity loans and home equity lines of credit are not the only options for homeowners looking to leverage their home equity, and there are several circumstances where refinancing may prove to be the better option. Refinancing allows a homeowner to withdraw their home equity to finance anything from a major home improvement project to a new car. If refinancing doesn’t sound like a good option for you, but you still want to work for a home equity loan, read up on how to get equity out of your home without refinancing.

One of the biggest advantages of a refinance, however, is its ability to lower monthly payments and payoff terms for homeowners. Say a home buyer purchases their home when interest rates are high and incurs a 5% annual percentage rate (APR). As time passes, the variable interest rate may lower while the borrower’s credit score simultaneously improves — and refinancing allows them to renegotiate their terms. Through a refinance, homeowners can lower their monthly payment and pay off their home loan quicker. 

There are countless different types of refinancing that pose unique advantages to borrowers, and understanding the benefits and limitations of each can be vital. 

Types of Refinancing

Cash-out Refinance

It’s important to consider cash-out refinance vs. a home equity loan. Most similar to a home equity loan, a cash-out refinance occurs when a borrower takes out a larger loan amount than their original loan — subsequently “cashing out” at up to 125% of the original loan value (minus what they still owe on the loan). A cash-out refinance may increase the overall amount paid in interest and monthly payment due to the increased size of the home loan, but it can be a great option for homeowners looking to realize their home’s value and turn it into some spending cash. If a borrower uses their home equity to add value to their home through additions, repairs, or renovations, they can theoretically use equity to accrue equity. 

Borrowers facing credit challenges may want to steer clear of a cash-out refinance, as loan underwriters may punish those with lower credit scores and worse loan-to-value ratios. 

Rate and Term Refinance

Marginally less complex than a cash-out refinance, a rate and term refinance is one of the most straightforward approaches to loan refinancing. This tool allows homeowners to renegotiate the terms of their loan in their favor — reducing interest rates, monthly payments, and even paying off their loan in less time. Typically, a rate and term refinance comes into play when interest rates are lower than when the loan was taken out, and can be a great way for homeowners to reduce their financial obligations. Generally, homeowners should wait until they have accrued at least 20% equity in their home, and most lenders require a 620 credit score (or higher) to negotiate a rate and term refinance. 

If interest rates favor the borrower, and they can meet the necessary requirements, there is very little downside to a rate and term refinance. However, homeowners looking for instant gratification via a cash infusion should explore other paths.  

Cash-in Refinance

If a cash-out refinance or rate and term refinance puts home buyers on the offensive, a cash-in refinance sees borrowers playing defense. At present, home values are at historic highs and continue to soar in many areas.3 While some aspiring home buyers and optimistic realtors may feel like this trend is here to stay, some predict that these unprecedented home prices are not built to last. In the event that home values do plummet, many borrowers may find themselves “upside down” on their loans as home values dip below principal loan amounts. In this situation, a cash-in refinance may be a strong option for homeowners looking to reduce their debts. 

Of course, it doesn’t have to take a housing market downturn for borrowers to want to take control of their debts! Homeowners who may not have the necessary equity or credit score for a rate and term refinance can fall back on a cash-in refinance — thus lowering their overall debt-to-income ratio. 

When Should You Refinance? 

The circumstances of each borrower will be different, and there is no one-size-fits-all approach when it comes to refinancing. Generally, however, the following circumstances can present strong opportunities for a refinance: 

  • A borrower has 20% equity in their home and a 620 credit score or higher
  • Average percentage rates of interest have dropped since taking out the initial loan
  • A borrower is planning on staying in the home for the foreseeable future 
  • A borrower’s credit score has increased since taking out the initial loan
  • A borrower has accrued enough money to cash-in and refinance for a 15-year fixed mortgage 

The Final Word From Truehold

Home equity loans, home equity lines of credit, and refinancing all offer their own unique advantages to borrowers, and can be great ways for homeowners to reap the benefits of their investments. Although these tools may benefit homeowners, they are ultimately designed to serve lenders — so be sure to proceed with caution before pursuing any of these avenues to ensure your best interest is protected. 

These are also not the only options, and those looking to tap into their home’s equity —without feeling like they are being taken advantage of — can do so through a sale leaseback agreement with Truehold. To explore alternatives to refinancing, HELOCs, and home equity loans and see if a residential leaseback agreement is right for you, download our free info kit. 

To explore alternatives to refinancing, HELOCs, and home equity loans and see if a residential leaseback agreement is right for you, download our free info kit or use our sale leaseback calculator.

Sources:

1. Investopedia. HELOC Draw Period. https://www.investopedia.com/heloc-draw-period-definition-5211694 

2. CNN. Home prices hit another record high in March. https://www.cnn.com/2022/04/20/homes/us-existing-home-sales-march/index.html  

3. Nerdwallet. How a Home Equity Loan Works. https://www.nerdwallet.com/article/mortgages/home-equity-loan 

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Written by
Lucas Grohn
Senior Manager of Sales at Truehold - A Thought-Leader in Real Estate
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Lucas Grohn brings over a decade of real estate expertise to his role, where he guides a team dedicated to innovative sales strategies. Known for his thought leadership and diverse experience, from managing brokerage operations to training agents at top firms, Lucas covers a broad span of real estate content for Truehold.
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Truehold's blog is committed to delivering timely and pertinent insights in real estate and finance, purely for educational and informational purposes. Crafted by experts, our content is thoroughly reviewed to guarantee its accuracy and dependability. Although designed to enlighten and engage, our articles are not intended as financial advice and should not be the sole basis for financial decisions. Our stringent editorial practices ensure the integrity of our content, empowering our readers with valuable knowledge.

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