As a homeowner, you have probably heard that you can use the equity that you’ve built up in your home, or the portion of the home that you own outright, in order to finance some of life’s big expenses, like education costs, medical debt or home renovations. You may not know how to actually borrow against your home equity, though, so we’re here to help you figure that out. Let’s take a look at home equity loans and home equity lines of credit, how they work, and how you can use them to pay for the things you need.
What is the Difference Between Home Equity Loans and HELOCs?
Without refinancing your mortgage, there are two ways to borrow against your home equity. You can either take out a home equity loan or a home equity line of credit (HELOC). While they may sound similar, they function very differently.
For example, a home equity loan is often referred to as a second mortgage because they work in a similar manner. With this type of loan, you’re given the money as one lump sum and then you make fixed monthly payments over the life of the loan in order to repay what you borrowed.
A home equity line of credit (HELOC), on the other hand, works more like a credit card. You’re given a line of credit that you can draw from, as needed, for a certain number of years. This is known as your draw period. During your draw period, you usually only have to pay interest on what you’ve borrowed. After your draw period is over, you enter the repayment period, where you can no longer borrow against your home and you have to start paying back both the principal and the interest on what you owe.
4 Fundamentals of Using Home Equity
Home equity and HELOC loans can give you much needed cash, but how you spend it determines whether tapping into your home’s equity is worth it. See our guide below for the 4 fundamentals of using your home’s equity.
- Choose the right type of loan
- Calculate monthly payments
- Use equity to decrease your interest payments
- Limit your use of equity
How to Choose the Right Type of Loan
Choosing between a home equity loan and a home equity line of credit may seem complicated at first, but in reality, it comes down to two distinct factors. You need to decide how you want to access your money and how you’d like your payments to be structured.
With a home equity loan, like a mortgage, your money is disbursed in one large lump sum. This makes it better suited to be used to pay for one-time costs like paying off large bills or consolidating other forms of debt. A HELOC, meanwhile, can be borrowed from as often as needed during your draw period, making it a better choice for ongoing costs like paying tuition or funding a renovation that happens in several different phases.
Then, there’s also repayment to consider. With a home equity loan, your payments are fixed, meaning they stay the same each month. This makes home equity loans a smart choice for those who need to make sure their payments fit into their tight budget.
While there are also fixed-rate HELOCs, they are rare. You’re more likely to find a HELOC that allows for interest-only payments during the draw period and a repayment of both the principal and interest once your draw period is over. Keep in mind that while this repayment structure keeps your payments low at first, the payments will go up once you enter your repayment period.
How to Calculate Your Loan Payments
Calculating your loan payments will depend on how much you borrow, as well as the interest rate that you’ve been given. Remember, the interest rate that you receive will depend on your credit score and the rate at which banks can borrow money.
To calculate your monthly payment on a home equity loan, you divide the amount that you borrowed and your interest rate by the number of payments you’ll make during the life of the loan. Since your payments on a home equity loan are fixed, you’ll pay the same amount every month.
For a home equity lines of credit, figuring out your payment is a bit more difficult. During your initial draw period, you’ll multiply your interest rate by the amount that you borrowed. Then, during your repayment period, your calculations will look more like those of a home equity loan. You’ll factor in what you’ve borrowed and your interest rate and divide that into fixed monthly payments over the remainder of the loan term.
The truth is that doing the math on a home equity loan or a HELOC can get complicated. Your best bet toward figuring out what your monthly payments will be is to use a HELOC-specific calculator, or better yet, have your lender work up the numbers for you before you sign on the dotted line.
How to Use Equity to Decrease Your Interest Payments
If you’re in a considerable amount of debt, another way to leverage your home equity is to use it to consolidate your outstanding debts and decrease your overall interest payments. This will not only help you streamline your debt into one manageable monthly payment, but also help you decrease the amount you pay in total, since less interest will accrue over time.
To do this, start by adding up your total monthly debt payments. Be sure to include your debt from all sources, including credit cards, medical bills and student loans. Once you know what that total number is, take out a home equity loan in that amount. Use the lump sum payment from your home equity loan to pay off all your debts from other sources. Once those are paid off, all you have to worry about is a singular monthly payment for your home equity loan.
The added bonus here is that a home equity loan is secured by your home, it will likely have a much lower interest rate than other unsecured forms of debt, especially credit cards and personal loans. This means that if you choose to use a home equity loan to consolidate your debt, you’ll be paying less overall. On the downside, the lender can take possession of your home if you choose to stop making payments.
How to Limit Your Use of Equity
While it’s important to know how to use your home equity, it’s also crucial to realize that borrowing against your home is a serious undertaking. After all, when you take out a home equity loan or HELOC, you also give the lender the right to foreclose on your home if you fall behind on your obligation to repay. The roof over your head is on the line, so you need to take things seriously.
With that in mind, it’s important to limit the use of the equity in your home to things that are truly necessary. While it may be tempting to use the money for less important expenses, like a vacation or a big purchase, you would be better served by saving up and waiting until you have the money in hand. At the end of the day, while the equity in your home is a valuable tool to have at your disposal, it’s also not one to be taken lightly.