Home Equity Loan Vs. HELOC: Which Is Better for You?

As a landlord, you may consider taking out a second mortgage to purchase additional investment properties or pay for expenses or improvements on your current rental. You have two options for second mortgages: home equity lines of credit (HELOC) and home equity loans.

While they sound similar, and both use the equity built up in your home to borrow money, they are quite different. Let's explore their pros and cons and which loan may be right for you.

What is home equity?

Home equity equals the current market value of your property minus the amount owed on your mortgage. For instance, if your home is worth $500,000 and you owe $200,000, you have $300,000 in equity. In many cases, you can borrow up to 85% of the equity in your home.

Using home equity wisely can be an effective tool for growing your wealth and a solid investment strategy. Also, because you're using your home as collateral, these loans tend to have better interest rates than unsecured loans, such as credit cards or personal loans.

However, using your home as collateral is not without risks. If, for any reason, you're unable to make your loan payments, you could lose your home to foreclosure.

Pro Tip: To estimate your home's equity, get an appraisal or use the estimated value tool found on websites like Zillow or Trulia. While these are not 100% accurate, they will give you a rough idea of your home's current value. After subtracting what's owed, you'll come up with the equity.

What is a home equity line of credit?

A HELOC is a revolving credit line that works much like a credit card. Instead of receiving one lump sum, as you would with a loan, you draw out funds as needed. As reported by Bank of America, you typically have 10 years to withdraw funds as long as you continue to make payments.

Your lender usually only requires interest payments for the first 10 years. Then, the repayment period begins, and you pay the principal plus interest for the next 20 years. You can also save money by paying part of the principal during the withdrawal phase. These loans are ideal for improvement projects, enabling you to take out only the money needed.

Pro Tip: Make sure to ask about early closure, annual and application fees that vary by lender. Some lenders also let you convert a portion of what you owe to a fixed rate.

The pros and cons of HELOCs

Pros:

• You can use this line of credit over and over again, making it beneficial for those investing in multiple properties.
• During the draw period, you may opt for low-interest-only payments.
• You only pay on the money used.

Cons:

• HELOCs usually have a variable interest rate that fluctuates with the market. While these may decrease, resulting in lower payments, they may also increase.
• Some landlords prefer the stability of a fixed rate.
• Prepare to budget for the increased principal and interest payments when the repayment period begins.

What is a home equity loan?

With a home equity loan, you receive the entire loan amount upfront. These loans usually come with fixed interest rates and terms ranging from 5-30 years. Investors may opt for this type of loan if they need a set amount for a down payment on another property.

Pro Tip: Closing costs for home equity loans are typically higher than HELOCs. Make sure to ask your lender for closing cost comparisons.

The pros and cons of home equity loans

Pros:

• Fixed interest rates offer greater stability.
• Easier to budget with set monthly payments for the life of the loan.
• If you secured a low-interest rate on your primary mortgage, these loans may offer a better option than a cash-out refinance.

Cons:

• Receive the full amount upfront, which you may end up not needing.
• Begin repaying the loan immediately.
• Using all the equity in your home may work against you if your property value declines. Called "underwater," it means you owe more than the home is worth.

Home equity loan vs. HELOC: Which loan is right for you?

If you want to invest in one property and know the exact amount needed for the purchase and any renovations, a home equity loan with a fixed interest rate may make sense.

If you want to invest in numerous properties over time, a HELOC lets you pull money out, pay it off and repeat. This type of loan may be ideal for fix-and-flip investors.

How can you get a HELOC or home equity loan?

To get a second mortgage, your lender will consider the equity in your home, your credit score and the debt-to-income ratio. While lenders vary, Bankrate reports the following requirements:

• Equity: Lenders usually require you to have at least 15% equity in your home.
• Credit Score: Lenders typically want to see a credit score of 680 or higher. While you may qualify for a loan with a lower credit score, these can come with higher interest rates, shorter repayment terms or lower loan amounts.
• Debt-to-Income Ratio (DTI): The DTI measures your monthly debts against your gross income. Lenders usually want to see a DTI no greater than 43% of your monthly gross income. They also factor in your new loan payment.

Pro Tip: Home equity lenders consider investment properties riskier than primary residences. For this reason, if you're obtaining a second mortgage from a rental property, you'll likely pay higher interest rates. They may also require a 700 or higher credit score, 20% equity, and at least six months of loan payments in reserves.

Real estate investors use these loans to make the down payment on rental properties, invest in a real estate investment trust (REIT) and for house flipping. As lenders vary, make sure you shop around. Because you're securing the loan using an existing property as collateral, it's critical that you have the cash to cover periods without rental income or downturns in the economy.