Line vs. loan: choosing home equity financing

Before the economic downturn, mortgage lenders frequently approved home equity loans and home equity lines of credit, often for 100 percent or more of the home's value. Lenders were willing to increase homeowner's mortgage balances because of the rapid rise of home values. In the current lending environment, requirements for home equity loans are more stringent.

"Many mortgage lenders do offer home equity loans, but these days most won't lend more than 90 percent of your home value," says Mark Goldstein, president of Capitol Funding in Rockville, Md. "You'll need at least 10 percent in home equity to qualify for the loan."

Others require a loan-to-value ratio (LTV) of 75 or 80 percent. Closing costs vary and include the typical variety of fees and origination points you typically find with other types of mortgages, which is why it’s advisable to inquire and shop around to get the best deal.

While you should consult a tax advisor about your individual circumstances, mortgage interest paid on a home equity loan or line of credit is typically fully deductible.

Home equity loan or line of credit

"The main difference between a home equity loan and a HELOC is that a loan is fully funded immediately," says Goldstein. "If you want to borrow $50,000, you will get that amount and then begin repaying that loan amount right away. A HELOC is a line of credit, so payments are based on the amount you use. For example, you could have a HELOC of $50,000 and only use $30,000."

Goldstein says he recommends a home equity loan rather than a HELOC for a home improvement project.

"If you have an estimate from a contractor and know how much your project will cost, it's usually better to take out a loan because you will know the payment and the pay-off date and your monthly payments won't vary," says Goldstein.

Home equity loans usually have a fixed interest rate, while HELOCs have variable rates, typically tied to the prime rate, such as the prime rate plus 1 percent. Some lenders who want to woo your other financial interests may offer prime minus 1 percent. Your interest rates change when the prime rate changes. Prime is currently at 3.25 and has been for a while.

"Generally interest rates are a little higher on home equity loans than on first mortgages," Goldstein says. Your interest rate will depend on your combined loan-to-value, which you can calculate by adding together your first mortgage balance and your home equity loan amount and dividing by the value of your home. If your loan-to-value is less than 80 percent, your interest rate will be a little lower than if you have a higher loan-to-value.

Home equity loan qualifications

Goldstein says that qualifying for a home equity loan is similar to qualifying for a first mortgage, with most lenders requiring a credit score of at least 700. He says home equity loans and HELOCs require full documentation.

"Most lenders want a debt-to-income ratio of 40 percent or less, although some might go to 45 percent," says Goldstein.

If you are applying for a HELOC, the lender will typically qualify you on the full amount of the loan regardless of how much you intend to use. For example, if you apply for a $200,000 line of credit, you must qualify to make payments on the full amount even if you only intend to use $50,000.

HELOCs usually have a specified draw period such as 10 or 20 years followed by a pay-off period.

Home equity loan shopping

Goldstein says that while homeowners can check with their current lender, not all lenders offer home equity loans.

"You should definitely shop around among several lenders to compare loan terms and interest rates," he says. "As long as you have 90 percent or less loan-to-value you can usually get some kind of loan. If your loan-to-value is 80 percent or less, it's a no-brainer for a lender as long as you meet the credit and debt-to-income qualifications."

Contractor or DIY

A lender may ask you to provide information about why you are borrowing from your home equity, says Goldstein, but that is mostly to make sure you are not acquiring too much unnecessary debt.

"A lender won't need to know whether you are hiring a contractor or handling your renovations yourself," he says. "There won't be any reason to have contact between your contractor and the lender."

Once you have estimated your renovation budget, consult with a lender to determine whether a home equity loan is right for you.