How Do Home Equity Loans and Lines of Credit Work?
Homeownership not only provides a sense of security and stability but can also be a valuable asset in times of financial need. Home equity loans and home equity lines of credit (HELOCs) are two financing options that allow homeowners to tap into the equity built up in their homes.
These solutions can provide access to funds for various purposes, from home renovations to educational expenses or debt consolidation. In this article, we’ll explore how home equity loans and lines of credit work, shedding light on their mechanics and benefits.
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How do home equity loans work?
A home equity loan, also known as a second mortgage, allows homeowners to borrow a fixed amount of money against the equity in their property (equity is the difference between the property’s market value and the outstanding mortgage balance).
A home equity loan is typically disbursed as a lump sum and comes with a fixed interest rate and fixed monthly payments over a predetermined term, usually ranging from 5-15 years. Just as with a mortgage, the borrowed amount is secured by the property, meaning that failure to repay the loan may result in foreclosure.
There are several advantages to a home equity loan:
- Fixed interest rates provide stability and predictability over the loan term, making it easier for borrowers to plan their finances.
- Lump-sum disbursement allows for immediate access to the funds, making it ideal for large expenses like home renovations or debt consolidation.
- Monthly payments are consistent throughout the repayment period, making budgeting simpler.
How do home equity lines of credit (HELOCs) work?
HELOCs, on the other hand, provide homeowners with a revolving line of credit that can be accessed as needed during a predetermined draw period, usually 5 to 10 years. The borrower is given a maximum credit limit, and they can withdraw funds as required, similar to a credit card.
The interest rate on a HELOC is typically variable, meaning it can fluctuate over time based on market conditions. During the draw period, borrowers can make interest-only payments or choose to pay both the principal and interest. After the draw period ends, a repayment period begins, during which the borrower can no longer access funds and must repay the outstanding balance over a fixed term.
There are several advantages to using a HELOC:
- HELOCs offer flexibility in borrowing, allowing homeowners to access funds as needed during the draw period.
- Interest is only charged on the amount borrowed, giving borrowers greater control over their interest expenses.
- HELOCs can be useful for ongoing expenses, such as home improvements or educational costs, as borrowers can withdraw funds multiple times during the draw period.
The following factors also contribute to how home equity loans and lines of credit work.
Equity and loan-to-value (LTV) ratio
Both home equity loans and HELOCs are based on the equity available in a property. Equity is calculated by subtracting the outstanding mortgage balance from the current market value of the home. Lenders typically have a maximum loan-to-value (LTV) ratio they are willing to lend against. For example, if a lender has an LTV ratio of 85% and the home is valued at $300,000 with an outstanding mortgage balance of $200,000, the homeowner may be eligible for a home equity loan or HELOC of up to $55,000.
Uses of funds
The funds obtained through home equity loans and HELOCs can be used for a variety of purposes, including home improvements, debt consolidation, educational expenses, medical bills, or other major financial needs. Unlike some other types of loans, there are generally no restrictions on how the funds are used, providing borrowers with flexibility and autonomy.
Repayment and interest
Home equity loans typically have fixed interest rates and fixed monthly payments over the loan term. Borrowers know exactly how much they need to repay each month, which can assist in budgeting and financial planning. HELOCs, with their revolving nature, allow borrowers to access funds as needed during the draw period. Interest is charged only on the amount withdrawn, and the minimum monthly payment may be interest-only during the draw period.
Putting it all together
Home equity loans and lines of credit offer homeowners a means to leverage the equity in their homes for various financial needs. Home equity loans provide a lump sum with fixed payments, while HELOCs offer a revolving line of credit during a draw period, followed by a repayment period. Understanding the mechanics, terms, and potential benefits of these financing options allows homeowners to make informed decisions and unlock the financial potential of their homes. It’s important to carefully consider the terms, interest rates, repayment schedules, and overall financial objectives when choosing between a home equity loan and a HELOC to ensure the chosen option aligns with your specific needs and goals.
Norway Savings Bank Home Equity Loans & Lines of Credit
At Norway Savings Bank, we want to simplify the borrowing process. Our local lending experts meet you where you are, take time to understand your needs and when we’ve found the right option, make the application process fast and easy. Whether you want to add another bathroom, pay for a child’s education or fix a roof, we are here to help. Ready to get started? Check out our Home Equity page, or contact a lender.