Homeowners are spending plenty on home improvements: $300 billion was spent on remodeling projects in the 12 months through June, up nearly 7% vs. the same period a year ago, according to the Joint Center for Housing Studies of Harvard University. Remodeling spending for the 12 months through June 2018 is forecast to rise another 6%, which is more than double the rate of inflation.
If you’re considering a big home renovation project that you anticipate you can’t pay for from your monthly cash flow or savings, a popular financing option is to take out a second mortgage.
There are two types of second mortgages: A home equity loan and a Home Equity Line of Credit (HELOC). Understanding how a home equity loan and a HELOC work will help you choose the right one to pay for a home renovation project.
Both types of second mortgages are reported to the credit bureaus; making a smart choice will help you maintain solid credit scores.
What a home equity loan and a HELOC have in common
Banks, credit unions, and other lenders offer home equity loans and lines of credit to qualified homeowners. Typically, you need at least 20% equity in your home to be a candidate for a home equity loan or a home equity line of credit (HELOC). Equity is the percent of a home’s appraised value that exceeds your current mortgage balance. For instance, if your home’s value is $300,000 and your mortgage balance is $200,000 you have $100,000 in equity, which represents 33% of your home’s value.
Lenders will pore over your household finances when considering your application for either a home equity loan or HELOC. The best interest rates are reserved for borrowers with the strongest credit scores. Typically, lenders will run the numbers to make sure that any loan, combined with all your other ongoing debts, doesn’t exceed 45% of your gross monthly income. (See also: How to Improve Your Credit Scores)
Most importantly, keep in mind that both types of second mortgages are “secured” loans. Your home is the collateral for the deal. If you can’t keep up with repayments, your lender has the right to force you to sell the home (or foreclose) to recoup the money it is owed. That’s just one more reason to be extra careful that you only borrow an amount you are confident you can repay, on time.
How a home equity loan and HELOC differ
The interest rate
The interest rate on home equity loans is fixed; the rate you are offered will never change over the life of the loan. Plus, it is an installment loan, meaning the monthly payment amount does not change either. Most HELOCs are variable-rate loans. The interest rate for a HELOC rate is tied to a benchmark index. As that index changes over time, so too will the interest rate charged on the HELOC. Currently, the initial rate on a HELOC for borrowers with strong credit scores is about a percentage point or so less than the fixed interest rate on a home equity loan.
Some lenders now offer a hybrid type of HELOC: It begins as a variable rate line of credit, but borrowers have the option of converting to a fixed rate. That fixed rate will be whatever the home equity loan rate is at the time you want to lock in a fixed rate on a HELOC balance. (See also: What is a Home Equity Line of Credit (HELOC)?)
Accessing loan funds
When you take out a home equity loan, the entire value of the loan will be given to you upfront in a single lump sum payment. You then must begin to immediately pay back the loan. A home equity loan can be for as little as 5 years or as much as 20 or 30 years. (Remember, the longer the loan term, the more in total interest you will pay over the life of the loan.)
A HELOC works like a credit card. You are given a revolving line of credit that you can use at any time. There is no interest due until you use the line. As you use funds, your line of credit will decrease. Pay back the money you have tapped, and your line of credit will be replenished to reflect your payment.
A HELOC has two distinct phases. During the “draw” period, which typically is for 10 years, you can borrow from your credit line. You may have the option of paying only interest on borrowed funds during the draw period. After year 10 the loan enters the repayment phase.
There are two repayment options. Some HELOCs require a balloon payment once the loan hits the repayment phase. That’s a one-time payment that covers the entire outstanding balance. Or you can opt for a HELOC that will convert your balance to a regular installment loan—say for 10 or 20 years. It’s smart to think through what repayment plan makes sense for you before you take out a HELOC.
Choose the right option based on how fast you expect to repay
If you need a big sum of cash up front—say to pay the architect and contractors for a major renovation or expansion—and you expect to take more than a few years to pay back the money, a home equity loan may be the way to go. With a fixed interest rate you don’t need to worry about the risk of interest rates rising.
If you anticipate you will be able to pay back the money in a year or two, a variable rate HELOC can save you money, as the current starting interest rate for borrowers with high credit scores is about one percentage point less than the interest rate for a home equity loan. It is important to keep in mind that a HELOC rate can change over time.
Right now, we are in a period where the expectation is that interest rates may trend moderately higher. For nearly two years, the Federal Reserve has begun to slowly increase its federal funds’ rate after keeping it very low during the financial crisis. As the Fed raises rates, it typically causes benchmark indexes, such as the prime rate to rise. That in turn, can cause variable-rate HELOCs to become more expensive. (See also: 8 Ways an Interest Hike Could Impact You)