Mortgages and HELOCs (Home Equity Lines of Credit) are two types of loans that are both backed by your home. When trying to decide what kind of loan is best suited to you and your situation, it's essential to know the differences between the two and the benefits and drawbacks of each. This article will explain how each type of loan works and explore what the key similarities and differences are.
- Mortgages and HELOCs are two types of loans that both use your property as collateral. This means that if you end up defaulting on your payments, you can end up losing your home.
- A mortgage is a fixed amount used to purchase property, while a HELOC is a revolving line of credit typically tapped for home improvements or renovations after a home is already bought.
- A mortgage can have a fixed or variable interest rate. Most HELOCs have variable interest rates.
- Mortgages and HELOCs share a lot of the same requirements for eligibility, such as a good credit score, Debt-to-Income Ratio at 43% or lower, and a steady income.
- Getting a HELOC is usually quicker than getting a mortgage. However, the timeline varies a lot and depends on your lender and location, among other things.
How Does a Mortgage Work?
A mortgage is a loan used to purchase property when you don’t wish to buy it outright using cash. Instead of paying the whole amount that the home is worth upfront, you make a down payment (the general rule of thumb is at least 20% of the total price), and get a mortgage to cover the rest. The home you are buying serves as collateral for the loan. The mortgage, which includes a principal amount and interest, is paid back in monthly installments over a determined period of time. Once you've paid off the whole amount you owe, you will own the property in its entirety. Mortgage rates can be either adjustable or fixed.
To be eligible for a mortgage, you need to meet certain requirements. The lender will typically run a credit check, and the higher your credit score, the lower your interest rate and mortgage payment will generally be. For a conventional mortgage, a score of 620 or higher is often required.
You will need to prove to the lender that you have a steady income. This can be done by showing bank statements, proof of employment, pay stubs, tax returns, and other documents. The lender also looks at your mortgage reserves – cash or any assets you have that can be easily converted into cash if you were to find yourself facing financial hardship and struggling to make payments. Investments in stocks, bonds, and funds, and money in checkings and savings accounts are some of the liquid assets that may be considered reserves.
The lender will also look at your DTI or Debt-to-Income Ratio. This is calculated by dividing your monthly debt payments by your gross monthly income. The Consumer Financial Protection Bureau (CFPB) recommends a DTI of 43% or less.
The process of getting a mortgage begins with you applying to a mortgage lender. The lender will first verify if you meet the requirements and will be able to pay back the loan. If you are approved, they will come back with an offer of a loan at a specific interest rate to be repaid over a set amount of time. If you accept the lender's offer, you will go through a closing process, where you meet with the seller of the property to pay the down payment, have them sign over the property to you, and sign documents.
Filling out the paperwork for the mortgage application won’t take long, but getting approved, having the appraisal done, receiving a final offer and finalizing the closing procedure can be a lengthy process. After researching mortgages and finding a property you want to purchase (which can also take quite some time), you’re looking at a timeline of approximately two months before you have the keys in your hand. According to Ellie Mae, a software company that processes mortgage applications, the average time to close purchase mortgage loans was 51 days in March 2021. Because there are so many steps in the process, however, there is no guaranteed timeline and the amount of time it takes to get a mortgage varies greatly.
The mortgage process also comes with a closing cost, which can include origination and appraisal fees, real estate commissions, taxes, insurance fees, title fees and more. The average closing cost is around 3-6% of the purchase price, but it varies depending on your mortgage lender, location and loan type.
How Does a HELOC Work?
A Home Equity Line of Credit (HELOC) is a type of loan that lets you borrow against home equity, typically to spend on repairs and improvements of the property. It uses your home as collateral, just like a mortgage. However, unlike a mortgage, a HELOC gives you access to a revolving line of credit from which you can borrow money, pay it back, and borrow again during the first phase of the loan called the draw period. During this time, you usually only pay interest on what funds you actually borrow. The draw period generally lasts five to 10 years and is followed by the repayment period, where you pay back your remaining balance through monthly payments of principal and interest. HELOC rates are typically adjustable and vary over time.
To be eligible for a HELOC, you need to meet a lot of the same requirements as for a mortgage, except for the mortgage reserves.
Just like with a mortgage, the lender will look at your Debt-to-Income Ratio, which needs to be 43% or lower. You will also still need a credit score of around 620, depending on your DTI and the amount of equity you have in your home.
The home equity you own is the current price of your property minus any balance you owe on mortgages and loans against it, calculated as a percentage. To be eligible to apply for a HELOC, the minimum equity required is typically about 15-20%.
HELOC lenders will also want to know that you can make payments and will therefore require you to prove employment and a steady income as well. Read more about the HELOC application process here.
When you apply for a HELOC, the lender evaluates the above-mentioned information to determine if you are a good candidate for a line of credit. If you meet the requirements, the lender will give you an initial offer. Following this, they will likely want to do an appraisal of your home to determine its value and then come back with a final offer.
Completing the steps described above and receiving a final offer typically takes between two and six weeks. The average processing time for HELOCs, from application to underwriter final decision, was 21 days in 2019, according to the Mortgage Bankers Association. The process can be shorter or longer depending on your situation. The last step is for you to visit the office to sign the paperwork, and then, after about a three-day waiting period, you can access your funds through online transfers or issued checks.
Getting a HELOC also comes with closing costs, in most cases of around 2-5% of the total loan amount, but it varies greatly depending on the lender. The closing cost can include application/origination fee, appraisal fee, title and escrow fees and fees for notaries and attorneys, among others.
Some lenders can get you through the process of getting a HELOC faster. Applying for a HELOC Card, rather than a traditional HELOC can help you speed things along, and it may also come with fewer fees. Learn more about traditional HELOCs versus HELOC Cards here.
Comparing Mortgages and HELOCs
Home Equity Line of Credit (HELOC)
Uses your home as collateral for the loan
Uses your home as collateral for the loan
Used to purchase a new property
Used for investments, such as home improvements and repairs, when you already have at least 15-20% equity in your property
Can have adjustable or fixed interest rate
Typically has adjustable interest rate
Requires down payment, a good credit score, low DTI, steady income and liquid reserves
Requires a good credit score, low DTI and steady income
You receive a lump sum and once you pay it off you become the owner of the property. You can regain access to funds with a cash-out refinancing
Allows for borrowing, repaying and borrowing again during the draw period upto a credit limit
Average time to close is about two months
Average time to close is less than one month
Closing costs of around 3-6%
Closing costs of around 2-5%
Has this article piqued your interest in applying for a HELOC? Aven can get you approved in as little as 15 minutes, and lets you access your funds through a convenient HELOC Card. Find out more and decide if it’s for you!