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Home equity is defined as the gap between the value of your home and what you owe on your mortgage. Put simply, it is the amount of your home that you actually own.
If you have equity, you may want to use it to increase the value of your home, pay off debt, or accomplish other goals. One way to do this is with a home equity line of credit, or HELOC.
A payout refinance is another way to tap into your home’s equity. Believable makes it easy Compare mortgage refinance rates from multiple lenders.
What is a home equity loan and how does it work?
A HELOC is a revolving line of credit that allows you to borrow money against a portion of your home’s equity, typically up to 85%. It works much like a credit card – you can withdraw as much or as little as you want, up to a set credit limit. Eventually, you pay back the amount you borrowed plus interest. Note that HELOCs come with variable interest rates, which typically move with the prime rate and can fluctuate over time.
A HELOC has two important phases: the draw period and the payback period. During the draw period, which can last five to 10 years, you use special checks or a credit card to borrow money if you want, making only minimal payments.
After the drawing period has expired, you can no longer borrow your credit limit. And you have to pay back the principal plus interest. Depending on your agreement with the lender, you may have to pay back the balance immediately, or you may have a period of time – typically 10 to 20 years.
It’s important to note that some HELOCs have balloon payments – larger lump sum payments that are due at the end of the repayment period to cover the balance. If your HELOC agreement involves a balloon payment, you may need to raise thousands (or even tens of thousands) of dollars at once.
Luckily, you have a few ways to get out of a HELOC balloon payment. If you have enough cash on hand, you can pay for your HELOC in cash before the balloon payment is due. You could also refinance your HELOC or use a balance transfer credit card with 0% APR or APR.
General use of a HELOC
One of the advantages of a HELOC is its versatility. You can use it to cover almost any type of expenses. Some of the most common uses for HELOCs are:
- Home Improvement Projects — If you’re looking to update your home, a HELOC is a great option. You can withdraw money to remodel your kitchen, add an office, finish your basement, or anything else. It’s a good idea to vote handyman Projects that increase the value of your home.
- Debt Consolidation – Consolidate your debt Using a HELOC can make sense if you’re overwhelmed with high-interest credit card debt. A HELOC can save you hundreds or even thousands of dollars in interest. However, remember that if you are unable to repay the loan as agreed, a HELOC could put your home at risk. Credit card debt is not secured by your home.
- Medical Expenses – Unfortunately, insurance doesn’t always cover all of your medical expenses. If you are facing out-of-pocket healthcare costs and don’t have the cash to cover them, a HELOC may be an option.
How to qualify for a HELOC
If you wish to complete a HELOC, you must meet certain qualification requirements. While each lender has their own unique set of criteria, most want to see a credit score of at least 680.
Lenders also look at your payslips and bank statements so they can understand your employment situation and the debt-to-income ratio (DTI), which compares the amount of your total income that goes toward debt. The lower your DTI, the better. Lenders typically prefer a DTI of 43% or less.
In addition, lenders will check your loan to value, or LTV, to determine how much money you can borrow. Your LTV is your current mortgage balance divided by the current appraised value of your home. Most lenders require your LTV ratio to be no more than 85%.
Let’s say yours The house is worth $300,000 and you owe $210,000 on your mortgage. In this situation, your loan-to-value ratio is 70%. If your lender offers HELOCs with a maximum LTV ratio of 85%, you’re in good shape.
Keep in mind that some HELOC lenders may have more lenient requirements. For example, if you come across a lender that accepts borrowers with lower credit ratings, take a good look at the interest rates and fees as they may be high.
When a HELOC makes sense
A HELOC can be a good option if you are looking to fund a home improvement project that will add value to your home. In this situation, you may be able to claim the mortgage interest withholding on your federal tax return, provided you meet all of the eligibility requirements. It’s a good idea to consult a tax professional if this is your goal.
You may also want to consider a HELOC if you are planning to buy a vacation home or other property. It can help you to cover the cost of deposit and closing cost.
Of course, HELOCs come at a price, so make sure you can afford the various closing costs before opening one. These costs depend on the lender, but may include application fees, appraisal fees, and admission fees.
When to think twice before getting a HELOC
While a HELOC is a good choice for some people, it is not for everyone. If you only need a small amount of cash, a HELOC is not worth it. Because fees can exceed the amount you want to borrow, you might be better off with a 0% intro APR credit card if you can qualify for one.
Even if you’re concerned that you might be spending more money than you actually need, a HELOC can send you into a cycle of debt. You should also avoid this financing product if you are unsure of your future earnings and unsure that you will pay back what you have borrowed.
Also, don’t use HELOC—or any other form of credit—to cover basic expenses like groceries and utilities. Instead, focus on how to increase your income and reduce your debt so you can improve your financial situation.
HELOC vs. Home Equity Loan or Cash Out Refinance
Home equity lines of credit aren’t the only way to tap into your home’s equity. You can also complete one Home equity loan or cash out refinance.
With a home equity loan, the lender makes a one-time payment that you pay back in monthly installments. ONE Refinance cash out replaces your original mortgage with a new loan for more than you owe on your home. You will receive the difference in cash, which you can use for almost all expenses.
Here’s a comparison of three ways to tap into your home’s equity:
Pros and cons of a home equity line of credit
Every financial product has significant advantages and disadvantages. A HELOC is no exception. By comparing the pros and cons of this option, you can make an informed decision for your unique situation.
- Withdraw money when you need it – HELOCs give you the flexibility to borrow at any time during the drawing period. That’s great news if you’re unsure how much money a home improvement project or other expense is going to cost you.
- Only pay for what you borrow – With a HELOC, you can borrow as much as you want, up to a set credit limit. But you only pay interest on what you actually use, not the total amount available to you.
- Can be tax deductible — If you’re putting your HELOC funds into a home improvement project to fix or significantly improve your home, you might be able to take that tax deduction of mortgage interest if you meet all the requirements.
- Favorable interest rates — Compared to some credit cards and personal loans, HELOCs have lower interest rates. That means you could potentially save hundreds or even thousands of dollars by going this route.
- Can use funds for any purpose — Whether you’re paying for major purchases like furniture or home repairs, or just want to go on vacation, a HELOC can help. There are no restrictions on how you can use the money you withdraw. However, think twice before risking your home to finance something that is more of a need than a need.
- Must have good credit – Generally you need one high creditworthiness to be approved for a HELOC. If you don’t have the best credit, this may not be an immediate option for you.
- closing costs – HELOCs are not free. You must pay closing costs equivalent to those of a first mortgage.
- Ongoing Charges — In addition to closing costs, some lenders charge annual fees to keep your HELOC open, often referred to as annual fees or membership fees. Fees may also apply if you don’t use your HELOC or cancel early.
- Unpredictable Interest Rates — Because most HELOCs have variable interest rates, your monthly payments can go up or down when it comes time to pay off your loan. Fluctuating payments can be stressful, especially when you’re on a tight budget.
- Foreclosure Potential — A HELOC uses your home as collateral. If you default on this, the lender can foreclose on your home.
Where to get a home product
You can find HELOCs, home equity loans, and cash-out refinances at banks, credit unions, and online lenders. While some lenders offer borrowers all three home equity products, others only focus on one or two.
In order to find the ideal option for your situation, it is important that you research, shop around and compare the products available to you. Find out the requirements, rates, terms and fees of each option so you can make the best decision.
If you decide that a payout refinance is a better fit for your financial goals, you can Compare mortgage refinance rates from multiple lenders in minutes with Credible.