What are the different types of home equity loans?
The world of equity lending can seem confusing at first. What’s the difference between fixed and variable rates? What does LTV mean? How is a home equity line of credit different from a home equity loan?
Once you understand the terminology and basics, it’s easier to see how a home equity loan can help you reach your goals.
What is home equity?
Home equity refers to the difference between the current value of your property and the outstanding balance on any existing home loans such as your primary mortgage. In other words, it represents the portion of your home value that you own and that increases over time as you make mortgage payments as well as through any appreciation in property value. Home equity financing can be used as a resource for various purposes:
- Home improvement projects: Tapping into your home equity may provide the funds needed to make significant renovations or improvements including remodeling your kitchen, adding a new room, or installing energy-efficient upgrades. These improvements may potentially increase your property value and enhance your living space.
- Debt consolidation: If you have high-interest debts, such as credit card balances or personal loans, you can use your home equity to consolidate these debts into a single loan payment. This may help you save money on interest payments and simplify your budget.
- Education expenses: Home equity can be used to finance higher education expenses for yourself or a family member, including tuition, books, and living expenses. By using your home equity to invest in education, you may be able to pursue a new career opportunity and improve your financial future.
- Car purchase: A home equity loan typically offers lower interest rates compared to traditional auto loans. This may result in significant savings on interest payments over the life of the loan, making it a more cost-effective option for financing a car. If you choose a loan with a longer term, you may have a lower monthly payment than you can receive with traditional auto loan financing, but you may wind up paying more in interest charges over the life of the loan.
These are just a few examples – typically, money you receive by borrowing from your home equity is yours to use for any needs.
Different types of home equity loans
Home equity financing commonly comes in the form of several loan options:
- Traditional home equity loan: A home equity loan gives you a lump sum, typically with a fixed repayment term of 10, 15, 20 or 30 years and fixed rate and payment. A home equity loan may be a good fit when you know how much you want to borrow and for how long, and when you prefer the stability of a fixed-rate loan over the potential changes of a variable-rate HELOC.
- Home equity line of credit (HELOC): A HELOC (pronounced "hee-lock") is a revolving line of credit that lets you withdraw funds, up to your approved credit line limit, during an initial term, called a HELOC draw period. While some HELOCs allow you to pay interest only during the draw period, when the draw period ends, the repayment period begins, where you cannot take out any additional funds and you will pay back the principal of the loan, along with interest charges. HELOCs typically feature variable interest rates (although some HELOCs use fixed rates). These are calculated by adding a margin determined at origination to an index like the national prime rate (which can fluctuate up or down over the life of your loan). The margin determined at origination could depend on a variety of factors including the amount borrowed, the length of the repayment period, and the borrower’s credit score, income, and combined loan-to-value (CLTV) ratio. A HELOC may be a good choice when you intend to borrow various sums from time to time rather than all at once.
- Cash out refinance: This type of home loan allows you to borrow a fixed amount against the equity in your home by refinancing your current mortgage into a new home loan for more than you currently owe, and you take the difference in cash. With a cash out refinance, the additional borrowed amount is combined with the balance of your existing mortgage.
Fixed rate vs variable rate home equity loans
Fixed rate home equity loans are loans where the lender provides a lump sum payment to the borrower and every month the percentage of interest charged on the loan remains the same. A fixed rate loan means you can budget your monthly payment exactly and not have that amount change and take you by surprise.
Alternately, with home equity lines of credit (HELOC), interest rates are often variable and may fluctuate with the market. This means that a year from now, your rate could be higher or lower than the day you signed up for the loan. Variable rates are based upon a publicly available index (like the prime rate or U.S. Treasury bill rate) which will fluctuate with this index plus a lender set fixed margin (i.e. variable rate = fluctuating index plus fixed margin).
What does loan-to-value ratio (LTV) mean?
LTV measures how much money you’re borrowing against the value of your home. For example, if you want to purchase a $400,000 home and need to borrow $320,000, to do so, your LTV ratio would be 80%.
What terms do home equity loans typically have?
Home equity loans come in a range of term lengths that vary depending on what a lender offers. Typically, the loans come with terms between 10 and 30 years.
The features of the loan can be similar regardless of the length, but the difference comes in with monthly payments and the overall cost of financing as longer-term loans may have a higher annual percentage rate (APR). If you wanted to borrow $40,000, the monthly payments on a 10-year loan will likely be much higher than with a 20 year loan because the total sum is divided over fewer monthly payments. However, it will cost you more interest to pay off the $40,000 over 20 years since you are charged interest over a longer period.
For example, if you are taking out a $50,000 home equity loan at 10% interest, a 10-year repayment term will cost you $660.75 each month for total payments of $79,290.44 for the life of the loan. The same amount and interest rate with a 30-year repayment schedule will cost only $438.79 each month, but you will have paid $157,962.88 against the loan when you complete payments*.
Closing thoughts: The right home equity loan type for you
There are four important factors to consider in choosing the right loan for you: what you can qualify for, the monthly payment, APR, and the total interest cost.
It may be worth it to you to pay some extra interest over the entire loan repayment period to have a lower monthly payment. If there is room in your budget for a higher monthly payment, you can save money in interest by selecting a loan with a shorter term.