Building equity is one of the key benefits of owning a home. While the value of it may increase over time, individuals only get access to the money when they sell or use it as collateral.
Businesses often use a line of credit (LoC) to manage their working capital needs. It allows them to strategically manage their investment and debt to minimize the cost attached but never get caught off-guard when an opportunity or an emergency arrives.
If individuals don't get access to the usual LoC, lenders are happy to offer them the modified version of it—termed as HELOC or home equity line of credit.
HELOC and home equity loans are usually the options available to all those looking to mortgage their home equity to borrow some money.
The primary difference between these two is that the former provides a revolving line of credit, while the latter offers a lump sum payout as a loan. If someone is confused about which is the right choice for them, this article discusses the HELOC and a home equity loan in depth.
What is a home equity loan?
"A home equity loan is a loan secured against the equity in an individual's home. Home equity is the difference between the current market value of the house and the remaining mort. Hence it increases as house prices rise."
-Macroeconomics: Institutions, Instability, and the Financial System
A home equity loan is a fixed-term loan that a lender grant based on the value of the equity in the borrower's home. Also referred to as second mortgages, it means that the borrower can borrow a certain percentage, usually limited to 85% of the difference between the value of the home and the outstanding loan balance against it.
The home equity loan offers the borrower a lump sum with a fixed interest rate. It also includes a schedule of fixed payments for the loan's term.
Loan collateral and equity loan terms
Here, the individual's equity in their home serves as collateral. Also known as a second mortgage, it only works if there is enough equity in the house. The loan amount is usually limited to a certain percentage, say 80% or 85% of the property's appraised value, and is based on several factors. These factors comprise the CLTV (combined loan-to-value) ratio and the individual's credit score and credit history.
In most cases, a home equity loan includes loan processing, loan origination, appraisal, and recording fees, with many lenders choosing to charge a nominal prepaid interest (1% or lower). In most cases, the interest rate is fixed and won't change during the loan term. Also, equity loans are rigid with their repayments which are fixed and apportioned in equal amounts over the life of the loan.
If an individual applies for an equity loan, they will get the approved amount upfront, and the loan term is between 5 and 30 years. The borrower will know the periodic amount due upfront, enabling them to plan repayment more precisely.
Let us consider an example:
Mr. X has a home worth Rs. 30 lakh and borrowed Rs. 25 lakh as a home loan. The individual still owes Rs. 15 lakh, whereas the property value has appreciated to Rs. 34 lakh.
In this case, the home equity value would be Rs. 19 lakhs (34 lakh - 15 lakh).
Pros and Cons of Home Equity Loan
Pros
Get a lump sum amount upfront
An option to pay a fixed monthly payment over a predecided period
Secure a lower home equity loan rates interest than personal loans or credit cards because of collateral being involved
An option to choose a longer repayment term of up to 30 years
Cons
Chances to lose the home if payments are not made
If too much equity is used at once, it can work against them if the property value declines significantly.
Inability to raise more funds in an emergency
Home Equity Line of Credit (HELOC) Meaning
"A HELOC loan is different from a traditional mortgage loan as the borrower is not advanced the entire sum upfront but uses a line of credit to borrow sums that total no more than the agreed amount, similar to a credit card and usually with an adjustable rate."
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As the name suggests, HELOC or home equity line of credit is a revolving credit line that gives an individual access to a pool of money. These loans are an excellent option to cover ongoing costs, and there are two phases involved—the drawing phase and the repayment phase.
Here, the borrower can draw for around ten years, and the lender has a credit line allowing them to borrow funds whenever the individual requires. The repayment phase is more extended and lasts between 10 and 20 years in most cases.
Loan collateral and HELOC terms
HELOCs share similarities with credit cards and equity loans. While the loan amount is dependent on the equity in the home of the individual, similar to how equity loans function, the forwarded amount is a revolving credit identical to how credit cards go about their business. The collateral here is the home, which means that if an individual misses repayment beyond a limit, the lender can attach the house to get their money back.
Like with a home equity loan, HELOC terms can be bifurcated into two parts—the draw period and the repayment period. The draw period (when the borrower can draw money) is available for around ten years, whereas the repayment period can last for an additional 20 years.
A HELOC inadvertently comes with a variable home loan interest rate. It means that the interest can change over the years, which affects the periodic amount due. An individual can find it inaccessible, but some lenders offer fixed HELOC interest rates, but it also depends on their creditworthiness, reputation, and the sum in contention.
If an individual is in the draw period, they are most likely to only repay the interest for that duration. However, as soon as the period expires, the repayment amount grows significantly, including the interest. So, to prevent a shock, the individual must understand how it works and be prepared for the steep rise.
Let us consider an example:
Mr. Y has a home with an appraised value of Rs. 40 lakh and has a pending home loan amount of INR 10 lakh. He has applied for a HELOC with the said home as collateral. The lender approves the loan to the tune of 60% of the home equity with a draw period of 10 years. It means that Mr. Y can withdraw a maximum of INR 18 lakh ((40-10) lakh x 60%) during the loan term.
Depending on the amount withdrawn and the date of withdrawal/s, the lender will levy interest on the amount forwarded.
Pros and Cons of HELOC
Pros
Ability to withdraw money as required till the limit expires.
Pay interest only for the amount withdrawn.
Flexible repayment options, with the option to convert a part of the liability to fixed rates.
Interest rates can reduce if your credit score improves or if the overall market rate falls.
Cons
Interest rates can spur up suddenly because of external factors or if your credit score goes down.
Because of variable rates, payments fluctuate.
Can push individuals toward impulse spending.
Key Differences between Home Equity Loan and HELOC
Here are the key differences between a HELOC and a home equity loan:
Particulars
Home Equity Loan
HELOC
Interest rate
Fixed
Variable
Amount forwarded
Lump sum at the beginning
Line of credit
Repayment
Fixed repayments periodically
Amount changes over time
Repayment term
Starts as the lump sum is disbursed
Repayment is limited to interest-only during the draw period. Principal repayment starts in the repayment phase.
Best for
Lump sum capital needs (for example: starting a business)
Periodic cash requirement (for example: for managing the working capital needs of a business during an emergency)
What is a good alternative to a HELOC or a home equity loan?
While HELOCs and home equity loans are good options for those looking to use their home equity as collateral, here are some options for those not willing to risk their homes for getting a loan sanctioned:
Personal line of credit
For all those looking for a HELOC alternative, a personal line of credit would serve their purpose right. Lenders offer it to people with good creditworthiness, and it is a revolving credit account that doesn't have any collateral backing it. While these allow withdrawal similar to HELOCs, the repayment period is significantly shorter, sometimes a few months or up to five years.
Personal loan
An unsecured loan is similar to a home equity loan but without the home equity backing it. It is a collateral-free offering that carries a higher interest rate. The amount is paid upfront as a lump sum and depends on the individual's creditworthiness and a fair to good credit score. While the loan period is shorter with a personal loan, the individual has the option to renew it periodically.
What are the requirements for a HELOC or a home equity loan?
Here are the criteria set by most lenders for approval of a HELOC or a home equity loan:
Fair to good credit score (preferably over 600)
Home equity of 20% or more
A history of stable and verifiable income
How to choose between a HELOC and a home equity loan
Now that an individual understands the pros and cons of both the options and how they function, it is vital to make the right choice for their specific use case.
Here are the situations when a home equity loans would suit them better:
If the individual requires a lump sum upfront for any specific need
If they prefer a fixed-interest loan
If the individual requires a precise sum to borrow
If they have a good credit score and can secure a loan at a lower interest rate
Here is when a HELOC is more likely to suffice:
The individual requires frequent small forwarding’s instead of having to settle a lump sum upfront
They have no idea of the total loan amount they would require over time
If the individual has a strong credit profile, preferably a credit score over 680
If the individual needs a low-interest loan against their home equity
Wrap up
HELOCs and home equity loans are terrific options for those willing to use their home equity as loan collateral. Unfortunately, with the recent pandemic incursions, some lenders have tightened their qualifications, which has meant that these loans are harder to come by.
When choosing between a home equity line of credit vs loan on home equity, there are clear advantages for each. These cater to specific use cases and are an excellent second loan option. So, whether an individual is looking to renovate their home or improve it, these options suffice.
If an individual is short of funds or cannot get any of these loans approved, Tata Capital is there for all loan-based needs. Avail a home loan anywhere between Rs. 5 lakhs and Rs. 5 crores with us at the most reasonable interest rates.
Plus, we offer tailor-made options for helping individuals purchase or construct a home with the ability to choose EMIs at their convenience. Check your home loan eligibility criteria and home loan EMI with our calculators.
Click Now to learn more about Tata Capital Home Loan.
23 September 2022
10 mins read
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