When it comes to harvesting the equity of your property(s), primary residence or investment, financing new investments or other major expenses, two popular options today often come to mind: Home Equity Line of Credit (HELOC) and Home Equity Loan (HELOAN). While both offer homeowners the ability to borrow against the equity they’ve built up in their homes without refinancing or replacing their existing first lien mortgage, there are key differences between the two that can significantly impact your financial strategy and goals. Let’s delve into the distinctions between HELOC and HELOAN to help you make the most informed decision.
HELOC (Home Equity Line of Credit):
A HELOC operates much like a credit card, allowing homeowners to borrow funds as needed up to a predetermined credit limit. Here’s how it typically works:
- Access to Funds: With a HELOC, homeowners can access funds as needed during a specified draw period, usually ranging from 5 to 10 years. The AIO (All in One- My (Caeli Ridge’s) Favorite) on the other hand, actually gives you access to the line for 30 years, one of the many advantages of that loan product. But I digress. Whatever the draw period, you can borrow (draw) funds at your discretion, repay them as quickly or slowly as you choose or are able, and then borrow again, just like a revolving line of credit.
- Variable Interest Rate: HELOCs will almost always come with variable interest rates, which means your payments may fluctuate over time based on the index (the variable part of whats called your fully indexed rate (index plus a margin)) it’s tied to. There are many indices out there, the one most commonly used for 2nd lien HELOCS is the Prime Rate (as of this newsletter is currently posting at 8.5%). Depending on a variety of variables this can result in lower initial interest rates compared to fixed-rate loans, it also introduces the risk of payment increases if interest rates rise. However, two things; first see bullet #3 below and 2nd, a higher variable rate on an open-ended revolving line of credit when taught to be used strategically can actually save thousands even hundreds of thousands in interest compared to even a much lower fixed rate close ended (amortized) mortgage- *search velocity banking or infinity banking concepts (think AIO)
- Interest-Only Payments: During the draw period, borrowers will have the option to make interest-only payments, providing greater flexibility in managing monthly cash flow. IO (interest only) payments will be lower than PI (principal and interest) payments even when the IO rate is higher in many cases. And because the first 10 years or so of say a 30 year fixed principal and interest loan, that payment is 95%+ interest and 5% principal. So unless your exclusive goal is to keep that mortgage for longer than that amount of time the IO type mortgage can yield some advantages. However, once the HELOC draw period ends, your payments will likely increase because the outstanding principal balance at that time will become a PI payment and over the remaining term of the loan. The most common 2nd lien HELOC term is a 10 year IO draw period followed by a 20 year repayment period. This means that at the end of the first 10 years your remaining balance will be PI amortized over a 240 month period of time- as opposed to say a 360 month amortization you would see with a 30 year fixed mortgage. The longer the amortization the lower the payment.
- Flexible Use of Funds: HELOC funds can be used for various purposes, including investing funds for a return (real estate), home renovations, debt consolidation, education expenses, or unforeseen emergencies. Reminder, monies used/interest paid for investing and home improvement purposes are tax deductible.
HELOAN (Home Equity Loan):
Unlike a HELOC, a HELOAN provides homeowners with a lump-sum payment upfront, which is repaid over a fixed term with a fixed interest rate. Just like your fixed rate first mortgage only in second lien position- which means in the event of default this loan gets paid off second. Which holds higher risk- higher risk, expect a higher rate. Here are the key features of a HELOAN:
- Fixed Interest Rate: HELOANs will come with fixed interest rates, providing borrowers with predictability and stability in their monthly payments throughout the loan term.
- Lump-Sum Payment: With a HELOAN, you receive a one-time lump-sum payment at the outset of the loan. While there are certainly circumstances where the HELOAN option makes sense, I personally prefer the revolving HELOC option. Unless you have plans to use the funds of the HELOAN right away, getting the funds all at once means you’ll be paying interest on money that isn’t yielding a return yet. The HELOC for this reason is superior because you’ll only ever pay interest on monies drawn. So if you will be deploying those funds upon receipt or you can’t qualify for the HELOC type loan, or you do not want to refinance your first lien mortagage the HELOAN is a great option.
- Fixed Repayment Schedule: HELOANs have a set repayment schedule, usually ranging from 5 to 30 years, during which borrowers make regular monthly payments consisting of both principal and interest. I strongly advise my clients against any shorter term (amortization) loans- second and first lien. Especially for investors, taking a shorter-term amortization will only prove to negatively impact a DTI (shorter term = higher payment). If you want to pay less interest or pay off a loan quicker, you can accomplish that exact thing with a 30 year fixed mortgage by simply applying any difference in payment (think 15 year vs 30 year) between two with your 30 year mortgage payment every month.
- Predictable Payments: Because the interest rate and repayment terms are fixed, borrowers know exactly how much they’ll owe each month, making it easier to budget and plan for future expenses.
Choosing the Right Option:
Deciding between a HELOC and a HELOAN ultimately depends on your financial needs, goals, and preferences. Here are some factors to consider:
- Usage Intentions: If you have ongoing or variable expenses, such as home renovations or education costs, a HELOC’s flexibility may be advantageous. However, if you require funds for a specific purpose with a defined budget, a HELOAN may be more suitable.
- Interest Rate Preferences: If you’re comfortable with potential fluctuations in interest rates and prefer flexibility in accessing funds, a HELOC’s variable interest rate may be acceptable. Conversely, if you prefer the stability of a fixed interest rate and predictable payments, a HELOAN may be preferable. *Pro tip: Google historical index values of the index tied to the mortgage you are securing and look back 25 years to determine how often and by how much that index changes and then look at overall current historical average of that index. This will give you good insight about setting expectations of the variable nature of that loan type.
- Repayment Strategy: Consider your ability to make monthly payments and your desired repayment timeline. If you prefer the option of interest-only payments during the draw period, a HELOC may align with your short-term cash flow needs. However, if you prefer a structured repayment plan with fixed monthly payments, a HELOAN may be more suitable.
- In Conclusion
Both HELOCs and HELOANs offer investors and homeowners valuable options for leveraging their home equity to achieve their financial goals. By understanding the differences between the two and evaluating your individual circumstances, you can make an informed decision that aligns with your needs and objectives. Whether you prioritize flexibility, stability, or a combination of both, exploring these options with Ridge Lending Group will help you unlock the full potential of your home equity.
Disclaimer: This article is for informational purposes only and should not be considered financial advice. Be sure to consult with a qualified financial advisor or mortgage specialist to discuss your specific situation and determine the best course of action for your individual needs.
