If you own a home and have equity in it, you can borrow money against that equity for big expenses like renovations, to buy a car, or college tuitions. There are two ways to tap your home equity: a home equity loan, and a home equity line of credit (HELOC). There are subtle but important differences between the two products, and you should know the particulars before making an expensive decision.
A home equity loan is favored by many homeowners due to its lower interest rates compared with other products. This kind of loan allows you to tap into a percentage of the equity in your home (usually 80 - 90 percent) as a lump sum and then repay it, like a regular loan. The amount you will get depends on the equity in your home - the surplus difference between what your home is worth and and you have left to pay on your mortgage.
A home equity line of credit (HELOC) on the other hand, works more like a credit card where you can repeatedly borrow against your equity and pay it back, creating a rotating balance. The term of this kind of loan ranges from five to twenty years. Unlike a home equity loan, which has a fixed rate of interest, a HELOC’s interest is variable, depending on the market. This means that your payment can go up or down.
Whichever product you choose, you’re going to need strong credit to qualify for any advance on your home equity. Your score will need to be at least in the high 600s to even get a chance, and you won’t get the best rates unless your score is in the 700s. Then there’s your debt-to-income ratio, which is the sum of your monthly payments divided by your income. DTI ratio cannot exceed 43% of your gross monthly income for most lenders.
As to whether you should take out a home equity loan, that depends on your situation. These loans are great for when you know exactly how much you need and want to lock in a good rate, especially now when rates are rising. If you are planning on using the money to do work on your primary or secondary residence, you can get a tax break on the interest! All of these are good things. The most important consideration, however, is that you do not squander your home equity on frivolous purposes. That there is a terrible idea.