How Home Equity Loans & HELOCs work: rates, terms and repayment
Home equity products are a great way to tap into the piggy bank that’s hiding in the value of your home. From debt consolidation to home improvement and even big-ticket purchases like a dream vacation, home equity products can be the perfect resource to get the cash you need.
Types of home equity loans
Home equity products available to homeowners include:
- Traditional Home Equity Loan: This type of loan allows you to borrow a fixed amount of money in one lump sum, usually as a second mortgage on your home in addition to your primary mortgage. With a traditional home equity loan, you can expect the interest rate, loan term and monthly payment amount to be fixed.
- Home Equity Line of Credit (HELOC): This product is considered revolving credit because it allows you to borrow money as you need it with your home as collateral. Most HELOC plans allow you to draw funds over a set amount of time known as the “draw period.” At the end of this period, you may be able to renew the credit line and keep withdrawing money, but not all lenders allow renewals. Some lenders require borrowers to pay back the entire amount at the end of the draw period and others may allow you to make payments over another time period known as the “repayment period.”
- Cash-Out Refinance Loan: 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 loan, the additional borrowed amount is combined with the balance of your existing mortgage.
Each home equity option varies slightly, and each variation offers different rates, terms and repayment options.
How term lengths affect monthly payments
The loan amount calculator from Discover® can show you how much you may be allowed to borrow based on your home value, remaining mortgage balance, and credit score.
We also provide a simple way to see how much your monthly payments would be for a home equity loan from Discover, with breakdowns for the different term lengths of 10, 15, 20, and 30 years.
In general, shorter terms mean higher monthly payments and longer terms will allow for lower monthly payments—shorter terms will accrue less interest charges against the loan than longer terms. Longer term loans will ultimately cost you more.
While the interest rate may stay consistent whether you select a short or long repayment term, spreading the loan out over a longer term will increase the overall amount of interest you will pay against the loan. For example, if you are taking out a $50,000 home equity loan at 8.99% interest, a 10-year repayment term will cost you $633.11 each month for total payments of $75,973 for the life of the loan. The same amount and interest rate with a 30-year repayment schedule will cost only $401.95 each month, but you will pay $14,4702.57 against the loan when you complete payments.
Your credit and available equity will typically determine your interest rate offers from lenders, but you will have the ability to select the term of the repayment period. The more you can afford to pay each month, the cheaper your loan will be in the long run.
Understanding the basics of home equity loans
The beauty of home equity products is the flexibility that’s available to you as a borrower. Because these products offer multiple terms and repayment options, you can choose options based on your individual needs.
To help you understand how rates, terms and repayment options work, let’s discuss each aspect as they relate to the different types of home equity products that are available to you.
First, let’s discuss popular loan terms and what they mean:
Rates are the amount of interest charged as a percentage of your loan amount paid to the lender for the use of the borrowed funds. Interest rates can be variable, meaning they change over time, or they can be fixed, meaning they stay the same for the duration of your loan term. Your interest rate is the amount you pay to borrow the funds you want.
Loan terms vary depending on the type of loan you obtain, and they merely describe the amount of time you have to repay the loan. A home equity loan term can range anywhere from 5-30 years. HELOCs generally allow up to 10 years to withdraw funds, and up to 20 years to repay. A cash-out refinance term can be up to 30 years.
Repayment options are the various structures a lender provides for you to repay the borrowed funds. Usually, you will repay your loan on a monthly basis, and your loan is paid in full when the term ends. In some cases, as with home equity lines of credit, you might pay the interest only during the term of the loan and pay the full amount of borrowed funds when the loan term ends.
Equity can be calculated by subtracting all debts secured by your home from your home’s appraised value. For instance, if your home is worth $275,000 and your current mortgage is $100,000, then you have $175,000 of equity.
Loan-to-value (LTV) ratio
Loan-to-Value Ratio is the amount of your mortgage divided by the appraised value of your home. For example, if your mortgage is $100,000, and your home is valued at $275,000 your loan to value ratio is 36%. This means 36% of your equity is mortgaged.
Each type of home equity product offers different rates, terms and repayment options.
How does a Home Equity Loan work?
A traditional home equity loan carries a fixed interest rate for the life of the loan. This means your interest rate will stay the same from your first payment until your last payment. The interest rate for a traditional home equity loan (also known as the APR or annual percentage rate) is based on several factors, including your existing mortgage balance, the value of your home, the term of the loan, the loan amount, your credit history and your income.
When you make payments on a traditional home equity loan, you are paying both the principal and interest on the loan with every payment.
Discover Home Loans offers 10, 15, 20 and 30 year home equity loans in amounts from $35,000 to $300,000.
Discover Home Loans offers 10, 15, 20 and 30 year home equity loans in amounts from $35,000 to $300,000.
The term of your loan dictates whether you have a high or low monthly payment. The longer the loan term, the lower the monthly payment. With a traditional home equity loan, once the term of your loan has ended and you made all payments on-time, you will have paid off all borrowed funds and interest.
With Discover Home Loans, your combined loan-to-value (CLTV) ratio must be less than 90%. You can calculate CLTV by taking your desired loan amount plus mortgage balance, then dividing that number by your home value.
Always be sure to factor in your first mortgage when calculating how much is available to you.
How does a HELOC work?
A home equity line of credit is usually tied to a variable interest rate. This means the rate can go up or down over the term of the loan because it is linked to an independent benchmark or index, like the U.S. Prime Rate. As this rate changes, your interest rate will change too, and it is not uncommon for lenders to add a few percentage points to your interest rate in the form of a “margin.” Keep in mind, the better your credit score, the better the interest rate options will be for you.
The term of a home equity line of credit can be as little as 5 or as much as 30 years. All borrowed funds are secured by the value of the equity in your home. This makes a home equity line of credit another good option for making large purchases. At the end of your loan term the balance of the loan becomes due.
Draw Periods and Repayment Schedules
With a HELOC, during the time that you withdraw funds (the “draw period”), which is as often as you need them, the repayment process often only requires interest-only monthly payments on the amount of money borrowed. Once the 5, 7 or 10-year draw period has expired, you may be required to make a balloon payment to pay off the entire loan balance or the HELOC can become a traditional 10, 15 or 20-year loan. Often, converting a HELOC into a traditional loan enables you to pay off the entire loan amount in manageable monthly payments for up to 20 years. Home equity lines of credit can typically start at $20,000, and you can usually borrow up to 90% of your CLTV. Discover Home Loans currently does not offer HELOCs.
How does a Cash-Out Refinance Loan work?
A cash-out refinance loan is a flexible home equity option. With a cash-out refinance loan, you can choose between a fixed or variable rate loan, and the term for a cash-out refinance loan can be up to 30 years.
A cash-out refinance loan is similar to a traditional home equity loan, except you will not have a second mortgage. This is because you are refinancing your existing mortgage into a new home loan for more than you owe, and you take the difference in cash. You should factor in the costs of refinancing when using a cash-out refinance. Generally, the rate on a cash-out refinance is lower than a home equity loan or HELOC, but there could be more fees and closing costs when refinancing. Discover Home Loans does not charge application, origination, or appraisal fees, and no cash is required at closing.
When you make monthly payments on a cash-out refinance loan, you pay principal and interest, just as you do with a traditional mortgage. By the time your loan term is up, your loan should be repaid in full.
Comparing home equity loans vs. HELOCs
While home equity loans and HELOCs both help you tap into your home’s equity, there are slight differences between these products.
Where home equity loans are disbursed as a lump sum, HELOCs allow the borrower to withdraw funds up to a given limit. During a HELOC withdrawal period, borrowers may only need to pay interest on the borrowed amount. Even after the withdrawal period ends, the borrower is still responsible for making payments until the amount borrowed is repaid plus interest.
Unlike the consistent, fixed interest rate of a home equity loan, some HELOCs feature variable rates, which means interest charges can fluctuate over the life of the loan.
The combination of a HELOC's variable rates and the withdrawal and repayment periods make HELOC repayment very unsteady, where a home equity loan can provide consistent payments over the entire life of the loan.
Pros & cons of home equity loans
Home equity loans from Discover feature fixed interest rates, which means your interest charges won't change.
Fixed monthly payments
With fixed rates, monthly payments for a home equity loan will remain the same over the entire term, allowing you to budget around your home equity loan.
High borrowing limits
Discover offers Home Equity Loans from $35,000 to $300,000 in available limits, depending on the equity you have in your home.