How to calculate home equity
For starters, you need to understand how to calculate your home equity. The simplest way is to subtract the amount you owe toward your home from its most recent appraised value:
Home equity = appraised value – amount owed
Remember, the amount you owe includes your primary mortgage as well as any other home equity loans or unpaid balances of other types of financing.
For example, if your home is currently valued at $300,000 and you have $120,000 remaining on your mortgage, then you have $180,000 worth of home equity.
Equity usually builds over time as you pay your mortgage or improve the market value of your home. Keep in mind that you calculate your home equity based on how much you still owe, not how much of your mortgage you have paid. Your monthly payments have included interest accrued.
What is a HELOC?
A home equity line of credit (HELOC) is a revolving credit line that lets you borrow money up to a predetermined credit limit. This credit limit is based on how much equity you currently have in your home.
HELOCs have two phases: a draw period, when you can access funds as needed, and a repayment period, when you will make regular payments toward the principal and interest. The draw period can last 5 to 10 years, while the repayment period can last 10 to 20 years.
Since a HELOC is a revolving line of credit, borrowers have no real limit on how much money they can borrow within the credit limit. You can take out money up to your limit, make monthly payments and then take out money again.
Home equity lines of credit function like credit cards. You can keep using them during your draw period as long as you pay your balance.
Some lenders may let you make interest-only payments during the draw period, which means you will not have to worry about the principal until the draw period ends. This setup can lead to a larger monthly payment in the long run, known as payment shock, but it can provide access to money when you need it.
Pros of a home equity line of credit
A HELOC offers advantages that include:
- High flexibility in the amount you borrow and repayment options
- Variable interest rates could cause your rates to drop if your credit improves, but they can also increase unexpectedly
- You pay interest only on the amount you draw, not the entire loan amount
These loans may have lower APRs compared to credit cards, making them a cost-effective borrowing option. HELOCs are often used for ongoing, flexible spending, such as house repairs, emergency expenses or home renovations where costs may vary.
Cons of a home equity line of credit
However, there are some disadvantages to a HELOC, including:
- Variable interest rates could raise your rates unexpectedly, making budgeting more challenging
- You can overspend during the draw period and build high-interest debt
- Your home is collateral, meaning you could lose it through the foreclosure process if you do not pay your loan
A HELOC works best when you have a plan for borrowing and repayment. Since the draw period can be as long as 10 years, it is important to be careful about how much you borrow. Still, HELOCs can be helpful for homeowners who manage their finances responsibly.
What is a home equity loan?
A home equity loan is a lump sum loan you receive based on the equity that you have in your home. Many lenders use the terms “home equity loan” and “second mortgage” interchangeably.
These loans typically have a fixed rate and fixed-term installment payments, making them more predictable than home equity lines of credit. Similar to personal loans, home equity loans are given in an upfront lump sum payment. That means borrowers need to know how much they need before applying for the loan.
The loan amount depends on how much equity you have built into the home, as well as your credit history and financial situation. Qualified borrowers can often get a loan as high as 80% to 90% of the home’s appraised value. The loan terms can vary by loan amount and lender, ranging anywhere from 5 to 30 years.
Depending on your lender, you may have to pay some closing costs, including appraisal fees and origination fees of roughly 5%, but these costs tend to be relatively minor compared to the value of the loan itself.
Pros of a home equity loan
The advantages of a home equity loan include:
- Fixed loan amount with predictable payments
- Fixed monthly payment schedule
- Lower interest rate compared to other refinancing options
Interest paid on most home equity loans may be tax deductible if used for home renovations or improvements, helping reduce your overall cost.
Borrowers can appreciate the predictability offered by a home equity loan, which prevents you from overspending like you might when using a HELOC.
Cons of a home equity loan
There are some disadvantages of a home equity loan, including:
- Lower flexibility if your financing needs change
- Need to refinance your home to receive a lower interest rate if rates drop
- Your home is collateral, meaning you could lose it through foreclosure if you do not pay your loan
With greater predictability comes less flexibility, which can lock you in if you discover your financial needs are greater than you initially thought.
Differences between a HELOC and home equity loan
To help you better understand the differences between a home equity line of credit and a home equity loan, here is a detailed comparison table. This overview highlights the main features, benefits and considerations of each option, allowing you to quickly see how they differ in terms of loan type, access to funds, interest rates, repayment structure and more. Use this as a handy reference when deciding which financing option best suits your financial needs and goals.
| Feature | HELOC (home equity line of credit) | Home equity loan |
|---|---|---|
| Loan type | Revolving line of credit | Lump sum loan |
| Access to funds | Borrow money as needed up to your credit limit during the draw period | Receive the full loan amount upfront |
| Interest rate | Typically variable interest charged only on the amount withdrawn | Usually fixed interest charged on the full loan amount |
| Repayment structure | Interest-only payments may be allowed during the draw period; principal and interest payments begin during the repayment period | Fixed monthly payments that include principal and interest |
| Draw period | Usually 5 to 10 years, during which funds can be accessed | Not applicable |
| Repayment period | Typically 10 to 20 years after the draw period ends | Varies, often 5 to 30 years |
| Use of funds | Often used for ongoing, flexible spending, such as home renovations with changing costs or emergency expenses | Often used for one-time, fixed-cost projects, such as home repairs or debt consolidation |
| Interest payments | You pay interest only on the amount you borrow | You pay interest on the full loan amount immediately |
| Collateral | Your home is used as collateral; failure to repay can lead to foreclosure | Your home is used as collateral; failure to repay can lead to foreclosure |
| Tax deductibility | Interest may be tax deductible if used for substantial home improvements | Interest may be tax deductible if used for substantial home improvements |
| Flexibility | High flexibility to borrow, repay and re-borrow during the draw period | Less flexible; fixed loan amount and repayment schedule |
| Payment predictability | Monthly payments can vary because of a variable interest rate | Predictable fixed monthly payments |
| Closing costs | May include appraisal and application fees | May include appraisal, origination and other closing costs |
| Risk of overspending | Higher risk because revolving credit can be accessed during the draw period | Lower risk because the loan is a fixed lump sum |
| Effect on credit mix | Adds revolving credit to your credit mix and credit history | Adds an installment loan to your credit mix and credit history |
How you could qualify for a HELOC or home equity loan
Home equity lines of credit and home equity loans both have similar eligibility requirements. Typically, you will need the following to qualify for this type of financing:
- At least 20% equity in your home, though this varies by lender
- Good credit, with a credit score on average over 620
- Reliable income for over two years
Some lenders, including credit unions, may approve high-risk borrowers, but the most competitive loan terms will go to borrowers who meet the above criteria.
Which option should I apply for?
So should you choose a HELOC or home equity loan? Both are useful options, though there may be specific times when one loan makes more sense than the other.
When to consider a HELOC
You might consider a HELOC when:
- You do not have a final idea of how much financing you will need
- You want flexible loan amounts and flexible repayment options
- You need to withdraw money over an extended period of time
For these reasons, you might prefer a HELOC for home improvements. Since the cost of materials tends to vary, having access to a revolving line of credit can give you the flexibility you need.
Just be careful about how much you draw during your draw period. Otherwise, you could find yourself building debt. Similarly, keep an eye on your variable interest rates, which can benefit you when they drop but become costly when they rise.
When to consider a home equity loan
You might consider a home equity loan when:
- You have a specific budget for how much you intend to spend
- You need a lump sum of funds for house repairs, debt consolidation or retirement savings
- You want a clear, fixed repayment schedule with predictable payments
A home equity loan might be helpful for those who need funds for things like debt consolidation or for paying contractors who offer a clear quote on a remodeling project. You will also appreciate the repayment schedule and fixed interest rate. But if interest rates drop during your loan term, you will need to refinance to lock in a preferable rate.
