Equity-Based Loans Versus Home Equity Agreements

Homeowners who have built equity in their homes are sitting on potential cash – often, a sizable amount. How to access it though, can be a conundrum. With both loan and no-loan options available today, it can be hard to know which to choose. Here, we’ll outline both types for you. 

At a high level, an equity-based loan is money that you borrow, using your home as collateral. Collateral is a valuable asset that you pledge to provide security to the lender. If for any reason you default (don’t make payments) on the loan, the lender can take the collateral – the house, in this case – and sell it to recoup their loss. 

Types of equity-based loans 

Home equity loan 

A home equity loan (HEL) is a type of second mortgage that allows homeowners to borrow against the equity they have in their homes. You receive a lump sum upfront, typically up to 80% to 90% of the equity you have in your home, with your home serving as collateral. You then repay that amount in monthly installments plus interest over a period of time (usually 5 to 15 years). The payment and interest rate stay the same over the life of the loan. 

To qualify for a HEL, homeowners usually need at least 20% equity in their homes and a credit score of at least 620, although many lenders will require a score of 680 or higher. You’ll also typically need a debt-to-income ratio of 43% or less. And because the home serves as collateral, you risk losing your home if you can’t make payments. 

Home equity line of credit   

Another type of second mortgage is a home equity line of credit (HELOC). A HELOC works much like a credit card in that it gives you access to a line of credit that you can use as you need. You borrow as much as you need when you need it (within your limit) and repay only that amount. In this way, a HELOC can be useful in situations where the homeowner is not sure of just how much they’ll need, and when. 

However, HELOCs typically have variable interest rates, so the monthly payments may change over the life of the loan. Qualifications are similar to those for a home equity loan, and again, will vary by lender. 

Cash-out refinance 

Unlike a HEL or HELOC, a cash-out refinance is not adding on another loan. It allows a homeowner to replace their current mortgage with a new mortgage. That new mortgage has new terms, which generally include a lower interest rate. Many borrowers choose to borrow a larger principal sum in the new mortgage, pay off the balance on the old mortgage, and then receive the difference as cash (the “cash-out”) at closing. 

The ability to borrow the larger amount could result from having paid down the balance of your existing mortgage, or from the increased value in your home due to market conditions. The amount you can borrow and receive as the cash-out portion will also depend on your loan-to-value ratio and credit score.  

Reverse mortgage 

A reverse mortgage is a type of loan that allows homeowners ages 62 and older to borrow part of their home’s equity as tax-free income. Unlike a regular mortgage in which the homeowner makes payments to the lender, with a reverse mortgage, the lender pays the homeowner. One of the most popular kinds of reverse mortgage is the Home Equity Conversion Mortgage (HECM), which is backed by the federal government. 

Homeowners considering a reverse mortgage have usually paid off their initial mortgage in full (or almost in full). There’s no monthly payment, and homeowners continue to live in their home. The loan must be paid off when the borrower dies, moves out (for 12 or more months, for any reason) or sells the home. 

Reverse mortgages come with a number of fees and can be expensive. They can be good options for some senior homeowners who have limited incomes and wish to stay in their homes. 

No-loan option 

An alternative for homeowners looking for a way to utilize their equity without additional debt is a home equity agreement (HEA).  

Unlike a loan, the HEA is an agreement in which you receive an upfront payment in exchange for a portion of the future value of your home. There are no added monthly payments and there’s no interest. The term of a HEA is typically 10 years. During that time, you can sell your home and pay the agreement’s equity percentage of the proceeds to the HEA provider. Alternatively, you can buy back your equity at any time during the term. Some HEA providers allow homeowners to do partial equity payments throughout the term. 

As the HEA is not a loan, qualification is generally easier and faster than with the traditional loan process. Credit scores in the 500s may qualify, and income requirements are flexible. Self-employed and retired homeowners are eligible. The amount you can obtain will depend on your home’s value and the amount of equity you have in it.  

Conclusion 

If you are looking to access your home equity – whether to pay off debt, improve your home or make needed purchases – the decision between an equity-based loan or a no-loan alternative will depend on your personal goals and circumstances. To find the best option for you, carefully research both loans and home equity agreements.