Borrowing money against a home isn’t as simple as applying for a new credit card. Not only do homeowners have to understand the differences between a home equity loan and line of credit, they must also calculate the costs that come with taking equity out of what’s probably their biggest asset.
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“It’s incredibly important before you take on any form of credit--including a home equity line of credit—that you assess your overall assets and credit picture,” says Adam Nash, COO of software-based financial advisement company Wealthfront. “Before approaching a home equity line of credit or loan, you have to ask yourself: is now the right time to take on more debt?”
During the heady days of the most recent real estate boom, people were using their homes as a piggy bank--drawing against the equity to fund vacations, make big-ticket purchases, take out other loans, or for debt consolidation. This strategy seemed to be working until home prices tanked, leaving many people with home equity loans or lines of credit they couldn’t afford to pay back.
Because of that, Nash says the decision to borrow against one’s home should be made after careful research and planning. “Just because you can do something in the financial world, doesn’t mean you should do it,” he says. “Home equity lines and loans can make a lot of sense to [fund] significant improvements to your house that has some real residual value. People have to be careful because it’s not a magic piggy bank to unlock.”
The decision on whether to take out a home equity line of credit or a home equity loan depends on how the money will be used.
With a home equity line of credit, borrowers draw down money over a period of time as they need it. With a home equity loan, homeowners get one lump sum that they have to pay back with interest.
Matt Potere, home equity product executive, senior vice president at Bank of America (NYSE:BAC), says a home equity line typically makes sense for people who want to have a line of credit available to cover unexpected expenses while a home equity loan is best to fund a specific project like a kitchen remodeling or a deck addition.
The interest rate should also play a role when determining the best product. The interest rate is fixed with a home equity loan whereas with a home equity line of credit, the interest rate fluctuates with the changes in interest rates.
Once a borrowing method is determined, homeowners need to evaluate their budget to determine how much to borrow.
To do that, Potere says owners need to know their home’s current worth and how much is left on their mortgage. “The loan to value is an important metric for customers to understand,” says Potere, noting that most lenders require a home appraisal when applying for a home equity line of credit or loan. An appraisal will determine the loan to value and thus how much owners can borrow. He adds that most lenders won’t loan 100% of the equity, but set a cap at 80% or 90%.
There are costs associated with a home equity loan or line of credit that need to be part of the decision-making process. For instance, some states add a tax at closing as well as have appraisal and annual fees.
Potere says banking costs vary by financial institution. “It’s important to ask about the costs and to understand the costs that a lender charges including third party charges the lender passes on to you.”
Borrowers also have to understand that their current financial situation will be a major factor in loan approval. Similar to securing or refinancing a mortgage, there’s an underwriting process where the lender checks the borrower’s credit score, income and debt to income.
“As borrowers prepare they need to understand what their credit is like, their source of income and debt,” says Potere. “All of that is taken into account as the financial institution makes a decision.”