Heloc and home equity loans: when are they a good idea? (2023)

Nowadays, people are not lining up for mortgage loans. thanks majormortgage interest rates– now sit downover 7%— The number of mortgage applications in the first week of August decreased by 27% compared to the previous year. Numberrefinancefell even more.

Home equity loansyhome equity lines of credit, Though? It's a completely different story. "There has been a huge increase in the number of borrowers applying for these types of loans in recent years," says Jeff Levinsohn, chief executive of the stock tracking platform House Numbers.

According to the credit bureau TransUnion, in the second quarter of 2023, the number of new home loans and Heloc loans increased by 53% and 21%, respectively, compared to the same period in 2021 (back then mortgage rates were below 3%).

"Over the past two years, we've seen a significant increase in our Heloc home equity and portfolio loans," says Susan Waite, who oversees the lending business at Point Breeze Credit Union in Hunt Valley, Maryland. "With first mortgage rates rising and home values ​​high, homeowners are choosing to stay in their current home and leverage their equity."

Why are higher rates driving homeowners to use equity products? What about a home equity or Heloc loan that could meet your financial needs? That's what you need to know.

How home equity loans and Helocs work

Home equity loans and Helocs (home equity lines of credit) are tools that allow you to take out loans against the equity in your home or part of the property you actually own.

With a home equity loan, you borrow a lump sum of your equity, typically 80% to 90% of the home's value, less the mortgage balance. You can then use the cash you receive as you please, repaying it monthly (plus interest) for 10 to 30 years. They are sometimes called second mortgages and the repayment of one will be similar to that of the original loan.

Helocks work a bit differently. While you are still borrowing from your principal and can use the money as you wish, you will not receive the borrowed funds all at once. Instead, the Heloc works more like a credit vehicle because you get access to a line of credit that you can use as needed.

The payment is also different. With Heloc, you will have a grace period (usually 10 years) during which you will have access to your funds. During this time, you will usually only have to pay interest on the money withdrawn. Then enter your billing period. For some Helocs, that means making monthly payments for the next 20 years. For others, you may need to make a balloon payment where you pay off the entire amount borrowed at once.

Why home equity loans are popular now

The last time the demand for capital products peaked was in the early 2000s, but after the 2007–2009 recession, lending largely fell out of favor. However, over the last two years there has been a resurgence that has gone hand in hand with increased demandConstruction zone.

According to the Center for Joint Housing Studies, Americans spent a whopping $473 billion on home renovations last year, 16% more than in 2021 and 30% more than in 2020. Many used home equity products to cover those costs.

While homeowners can technically use the funds they receive from home equity loans and the Helocs program for any purpose, according to the Mortgage Bankers Association, approximately two-thirds of all home equity borrowers used their loans for renovation or remodeling last year. Another quarter used the money for debt consolidation.

This surge in mortgage renewals has a lot to do with mortgage rates, which jumped from a low of 2.65% in early 2021 to 6.96% today. As mortgage rates rose, homeowners became less interested in selling (which would mean trading in a low interest rate for a much higher one) and were more likely to stay where they were and upgrade their existing homes. According to Zillow, 80% of homeowners have a current mortgage rate of 5% or less.

"With so many homeowners unable or unwilling to buy new homes, they are turning to equity products as a cost-effective way to improve the living conditions of their homes after renovations," says Alex Madonna, director of loan company LoanDepot, a mortgage lender. "Renovation can also increase the value of your home, and in some cases, taking out a loan against capital for home improvement can provide a tax advantage."

Equity products are a popular option when paying for renovations because, as Madonna points out, you can deduct the interest you paid on a home equity or Heloc loan in a similar way to your first mortgage if you itemize your taxes and use those funds to "buy , build or significantly improve your home.”

Home equity products also cost less than many other types of debt. According to the Federal Reserve Bank of St. Louis, the average credit card interest rate is now nearly 21%, while personal loans hover around 11.5%. At the same time, the average interest rate on home equity loans is less than 9%.

"Real estate equity products are almost always the cheapest debt instrument, so interest rates are lower than on credit cards and other unsecured debt," says Levinsohn. "It's a smart move to save money and lower your monthly payment, provided of course you don't go into debt."

Who can use equity products?

To take advantage of a home equity loan or Heloc, you need to start with a large amount of equity. Lenders typically require you to maintain at least 20% of your home equity after taking out a home equity or Heloc loan. This means that the mortgage balance and the home equity loan balance, combined, cannot be more than 80% of the total value of the home.

For example, if you don't have another mortgage, you can borrow up to $320,000 on a $400,000 home. If your first mortgage balance is $100,000, you can borrow up to $220,000 with a Heloc or home equity loan.

In addition to having sufficient equity in your home, you will need to meet other financial requirements. It varies by lender, but you'll typically need a credit score of 600 to 600 and a debt-to-income ratio of 43% or less - that's the sum of your monthly debt payments, including your new Heloc or home. Principal Loan Payments: Must be 43% of your monthly income or less.

"In general, a home equity loan or Heloc is great for people who work full time, have a predictable income, can afford the extra monthly payment, and have a credit score of over 640," Levinsohn says. "If you're paying off higher-interest debt with equity, that helps you qualify. You will cancel your monthly debt payment and often free up extra money each month.

Who should use the equity product?

If you have a lot of equity in your home, home equity products can be a smart choice if you need a lot of cash, as other financial products like credit cards or personal loans usually have credit limits. . .

“While personal loans of up to around $50,000 are fairly common, they are harder to obtain for larger amounts and often come with higher interest rates,” says Kyle Enright, president of mortgages at digital finance firm Achieve. "With a home equity loan or a Heloc, much higher amounts are available depending on how much equity you have in your home."

Home equity loan or Heloc?

Both types of loans allow you to turn your home equity into cash, but the right choice depends on several factors.

First, do you know exactly how much you need to borrow? If so, a home equity loan may be a smart solution. If you don't have a solid estimate or need access to money for a longer period of time (for tuition fees, for example), Heloc may be the best option as it will allow you to withdraw money as needed, up to the amount up to your credit limit.

You can even repay the amount borrowed and withdraw more later as long as it is still within the grace period. Plus, you only pay interest on what you borrow, allowing you to just leave your line of credit intact unless you really need it.

The size of the payments you can make also matters. If you need lower payments in the short term, typically for the next 10 years, Heloc may be a better option as you will typically only be required to pay interest on the first phase of the loan. Just remember that once you enter the payment phase, you will have to pay both interest and principal, and your payments will increase significantly, so make sure you have the funds ready.

Whichever home equity product you choose, be sure to check the fine print to see if your Heloc requires a balloon payment or has a floating rate like some, meaning your payments could increase over time. However, if you're prepared for it and fully understand the terms you're agreeing to, "a Heloc or home equity loan can be a great tool to keep you financially sound," says Madonna.