One reason for buying a home rather than renting is the equity that builds up over time as home prices rise and the mortgage principal is paid down. Homeowners can utilize the equity when the need for cash arises with two different financial products – a Home Equity Agreement and A home-equity line of credit. Each product has benefits and drawbacks and homeowners need to know the details before entering into a contract for either one.
What is a Home Equity Agreement (HEA)?
A Home Equity Agreement is a contractual agreement between an investor and a homeowner where the homeowner receives a lump sum of cash in return for giving up a portion of the equity in the home and future appreciation on it. A typical Home Equity Agreement usually has a finite term of 10-20 years. However, this is not a contract to be taken lightly, as the homeowner may be giving up a lot of future wealth for some immediate cash today. Homeowners should consider all of the ramifications of a HEA loan before acting.
What Are the Requirements of a Home Equity Agreement?
The requirements of an HEA agreement are not that difficult, but there are several to understand:
- The home must appraise over a certain value for the contract to work
- A low credit score may restrict the amount of funds the lender will give
- The homeowner must pay closing costs such as appraisal, origination fee, title insurance, etc.
- The home must be a single-family or multifamily with up to four units. Manufactured homes, farms and apartment buildings are not eligible.
- The HEA must be a first or second lien on the home. Homes with two mortgages are not eligible.
- The home must be in a state where an HEA mortgage is available. Not all states permit HEA.
- The equity in the home must be over a certain percentage level compared to the mortgage owed.
This last requirement is called the loan-to-value (LTV) ratio and it’s calculated by dividing the current loan balance by the home’s appraised value. That number is then multiplied by 100. If the current loan balance is $200,000 and the home appraises for $500,000, the LTV ratio would be 40%.
HEA lenders typically require 20% home equity or more before granting an HEA. Some homeowners might want to get a home equity agreement soon after buying their home, but just like with a HELOC, it would be tough to have enough equity in the home to make it worthwhile.
How Does a Home Equity Agreement Work?
When a homeowner contacts an investor or specialty lender, the lender sends out an appraiser to evaluate the home. Upon completion, the lender makes the homeowner an offer on the amount it will pay for a certain portion of the home’s equity. If the homeowner approves the terms, the lender completes the deal and the homeowner pays the closing costs.
The lender then pays the owner a lump sum and places a lien on the home for the agreed-upon amount. When the agreement expires or if the home sells first, the homeowner pays back the lender’s original principal, plus a portion of any appreciation on the updated home value.
Homeowners must maintain the value of their property by making repairs, paying their property taxes and purchasing homeowners insurance.
If the home's value decreases over time, the amount repaid will also decrease because the total given to the lender is based on the home's value at the end of the term. If the home is not sold, the homeowner will still have to repay the original principal plus a percentage of the appreciation within that time frame.
HEA Pros and Cons
There is an equal split between the pros and cons of the HEA loan. The pros of the Home Equity Agreement are:
- No monthly payments are required
- A Lower credit score may not be a factor
- There is no interest paid on the principal
- Few restrictions on how the money can be used
- Many HEAs do not include a prepayment penalty
The cons of the HEA Agreement are:
- May require more home equity than the homeowner wants to give
- The principal has to be repaid at some point or when the home is sold
- A large amount of appreciation could be lost
- The lender puts a lien on the home
- It’s not available in every state
What is a Home Equity Line of Credit (HELOC)?
A home equity line of credit is a revolving open credit line based on the equity in your home. You can borrow from it at any time, but as you do, your available credit amount decreases. As you repay your balance, your available credit goes up again.
When you first draw money from the line, you pay interest on that amount, but as you pay down the balance, the interest paid will decline.
A Home Equity Line of Credit has a variable interest rate. Therefore, in a rising interest rate environment, your interest could rise unless you pay down a substantial portion of the amount owed.
A HELOC is variable and based upon the prime rate, typically 3% higher than the Fed funds rate. The rate is usually the prime rate plus a margin, anywhere from the prime rate -1% to the prime rate +5%. If the Fed funds rate drops, the prime rate will usually drop and the HELOC interest rate will decline. If the Fed raises interest rates, the prime and HELOC interest rates will also rise.
One main benefit of the HELOC is that you can use the money for just about anything without questions. Most homeowners use it for large expenses such as home remodeling or costly repairs. Others use it to consolidate debts, such as credit cards, at higher interest rates. But it can be used to start a business, invest in real estate, medical expenses, college tuition or any other need.
Another benefit of the HELOC is the closing is usually within 1-2 weeks and the appraisal fee may be waived.
What Are the Requirements of a Home Equity Line of Credit (HELOC)?
The primary requirement is to have sufficient equity in your home. The amount owed on the home must be less than the current value. Most lenders will allow you up to 85% of the difference between the value minus the outstanding mortgage balance.
If the home is worth $400,000 and the outstanding mortgage balance is $300,000, the home will likely qualify for 85% of the $100,000 difference or $85,000.
The lender will review the credit score and history, employment, gross monthly income and total debt and run a Debt-To-Income (DTI) ratio. A minimum 620 credit score, verifiable income and 47% DTI or less are required. The better one’s credit and DTI, the more likely you will receive the full 85%.
How Does a (HELOC) Work?
The HELOC is similar to a credit card in that you can withdraw money from it so long as you don’t hit your borrowing limit and then pay it back with interest until the outstanding amount is zero.
For example, if you have a $40,000 line of credit and borrow $15,000 for a new roof, your new limit becomes $25,000. Over the next year, you pay back $12,000, plus interest and you now have $37,000 at your disposal. Then your air conditioner breaks down and you need $5,000 to replace it. You withdraw the $5,000 from the line and your new credit balance will be $32,000 plus interest.
HELOCs generally have a fixed time frame within which homeowners can borrow from their home equity. Some are 10 years and some are longer.
HELOC Pros and Cons
Like all financial products, HELOCs have pros and cons. The pros of a HELOC are:
- Appraisals are not always required. If one is needed, there’s usually no fee.
- There are very few closing costs.
- Once the line is set up, you should have instant access to cash
- There are no interest payments on any money you don’t use
The cons of a HELOC are:
- The HELOC uses your home as the collateral for the money you borrow.
- If you don’t make the required payments, you risk the loss of your home.
- The HELOC reduces your home equity (but only if you use it).
- You have to pay interest on the cash you borrow at a variable rate that can rise.
- You may be required to make at least one withdrawal within the first 30-90 days.
- Some HELOCs have an annual fee, whether you use it or not, so ask the lender in advance if there are any fees.
If the value of your home drops significantly, the lender can freeze your HELOC until the value rises again. This was very common after 2008 when the value of millions of homes declined sharply.
HELOC vs. HEA: Key Differences
The main differences between a HELOC vs HEA are:
- The HELOC requires interest payments, the HEA does not
- The HELOC allows you to keep the full equity in your home if you do not use it, whereas the HEA takes a portion of your equity at closing.
- With a HELOC, you keep any appreciation on the home. With an HEA, the lender gets a portion or all of the appreciation when the term expires or you sell the home.
- Some HELOCs have no closing costs, but there are closing costs on an HEA
- HELOCS require a 620 minimum credit score, while 500 will get HEA approval.
How to Choose Between a HEA and a HELOC
Your personal needs and history will determine which product is best. Suppose you have substantial home equity or believe your home will appreciate substantially over the next 10 years. In that case, you’re better off with a HELOC because you could lose a large chunk of equity or appreciation with an HEA.
On the other hand, if your credit history is not great or your debt-to-income ratio is high, the HEA might be a better product. It might also be a better alternative if interest rates are high and trending higher.
Remember that interest rates can change quickly if the economy becomes recessionary or inflationary. In 2020, during the COVID-19 pandemic, the prime rate was 3.25%. As of September 2024, it was up to 8%. Therefore, if you withdraw from a HELOC when interest rates are low, it’s a good idea to pay it down quickly.
Conclusion
A Home Equity Line of Credit and a Home Equity Agreement are different products that can provide a homeowner with needed funds for any reason. The requirements for these products are less stringent than a regular mortgage because the home becomes the collateral for the money received.
Each has pros and cons, including risks, so each person’s needs and situation should be carefully considered to make the best choice. Many fine lenders carry both products.