Home Equity Loan vs. Home Equity Investment: What’s the Difference?
For most people, their stake in their home is the most valuable asset they have. As such, many homeowners seek to tap into their home equity when they want to access money. For instance, perhaps the homeowner wants to renovate their home, pay off debt, or start a small business.
Until recently, home equity loans and home equity lines of credit (HELOCs) were pretty much the only ways to do this. Homeowners now have a new alternative: home equity investments.
Home equity investments advance cash upfront to homeowners much the same way loans and HELOCs do. However, they are very different from a structural perspective. In order to explain the differences, this guide provides an overview of home equity loans vs. home equity investments.
What Is Home Equity?
The first step toward understanding the differences between home equity loans, HELOCs, and home equity investments is to explain what “home equity” is. As a way to keep it simple, finance professionals often explain it to lay people in these terms:
Home equity represents your ownership interest in the property, minus any outstanding mortgages, loans, or liens. Two key factors are used to calculate it:
- The amount of money the homeowner has paid into the property over time
- Any appreciation in the market value of the home since its initial purchase
Buyers make a down payment of at least 3.5% to 5% of their home’s purchase price when they acquire a property, then finance the rest with a mortgage. Homeowners usually pay off their mortgages in monthly installments over long periods of time, which extend up to 25 or 30 years.
Each monthly installment follows a repayment schedule that commits some of the payment to the loan balance and some to the interest accruing on the loan. Home equity considers payments committed to the loan balance or principal, plus the homeowner’s initial down payment. Money that goes toward interest does not impact your home equity.
Real estate tends to appreciate in value over time. So, after a few years, many properties end up with market values that significantly exceed the price the homeowner paid. In such cases, the homeowner gains even more equity as their percentage stake in the property has risen alongside its price.
How Does Home Equity Work?
As an example, consider a simplified hypothetical case in which a buyer paid $250,000 for a home and offered a 10% down payment of $25,000. They then financed the remaining $225,000 with a 20-year mortgage at a 5% annual percentage rate. So, each year, they pay $11,250 of the mortgage principal off plus $562.50 in interest and fees.
After five years of regular payments, our hypothetical homeowner has put $81,250 into their home: $25,000 in the down payment, plus $56,250 toward the mortgage principal — not counting the interest. At this point, their equity stake would represent about 32.5% of the home’s value relative to its original purchase price.
But wait! Five years later, the homeowner’s local real estate market is sizzling and the property is now worth $320,000. The homeowner still owes $168,750 toward their mortgage principal, but the house is now worth $70,000 more than they paid for it. That extra $70,000 gets added to the $81,250 they have already paid in, creating a total of $151,250 in equity on the original purchase price of $250,000 they financed with a mortgage.
In short, their appreciation-adjusted equity stake comes out to 60.5%.
What Is a Home Equity Loan?
Now that we know what home equity is, we can explain how home equity loans work.
A home equity loan uses the homeowner’s equity stake in the property as collateral for a lump-sum cash advance. In exchange, the lender places what is known as a “lien” on the home. A lien is a type of legal claim on the property’s value, which allows for creditors to be paid off if the homeowner defaults on their financial obligations and triggers a foreclosure sale.
What Is a Home Equity Line of Credit?
Similarly, HELOCs follow a comparable structure: they draw on the borrower’s existing equity and place a lien on the home. However, instead of advancing a lump sum, HELOCs allow borrowers to access funds on an as-needed basis from a revolving credit account. Interest only accrues on the money the borrower actually uses instead of the entire sum, as is the case with a home equity loan.
HELOCs also involve a number of complex technicalities related to “draw periods” and “repayment periods” that do not apply to home equity loans. Of course, these distinctions are important. But for the purposes of this comparison, we’ll treat traditional home equity loans and HELOCs as two subtypes of home equity loans. By doing so, we can more clearly contrast them against home equity investments.
What Is a Home Equity Investment?
Home equity investments use a totally different financing model to advance lump sums of cash to homeowners in exchange for equity considerations. They aren’t loans, but instead, represent outside investments in future potential property appreciation.
So, a home equity investor essentially “buys” a stake in the property’s future value by purchasing a portion of your current home equity. Interest rates and monthly payments don’t apply to home equity investments. Instead, the homeowner pays back the investment at the end of the agreement. To do so, the homeowner pays off the investor by selling the property or finding another way to finance the repurchase of the investor’s stake.
How Do Home Equity Investments Work?
If home equity investments sound a bit complicated, then we can break it down with a simple example:
Firstly, suppose you have $125,000 of equity in a home with a market value of $250,000. Since you need $25,000, a home equity investor steps up with an offer to advance you that sum of money in exchange for a proportional percentage stake in your home equity. You have $125,000 in equity, so $25,000 represents 20%.
The home equity investment comes with an effective period, which specifies the maximum length of time that can pass before the investment must be settled. In most cases, effective periods range from 10 to 30 years. We’ll use 10 years for our example.
So, let’s say ten years after the investor purchased their equity stake, the home has been fully paid off and its market value has risen to $350,000. The investor holds a 20% stake, entitling them to $70,000.
At this point, the homeowner can sell the property and pay $70,000 of the proceeds to the investor. Alternately, they can use savings or refinance their home to come up with the $70,000 owed to the investor. The homeowner then recovers the sold-off ownership stake for themselves.
The homeowner benefits because they got the $25,000 they needed without having to pay any interest or make monthly loan payments. And on the other hand, the investor benefits because they turned their $25,000 investment into $70,000.
Home Equity Loan vs. Home Equity Investment
Both strategies offer homeowners specific benefits while also carrying particular limitations. Every situation is unique, and you should assess your own individual financial needs as part of your due diligence. That said, a few general principles can help guide your decision-making process.
Home equity loans and HELOCs can be appealing to homeowners with:
- Low personal debt loads
- No future plans to sell their home
- Strong personal attachments to their home
Additionally, home equity loans and lines of credit also tend to appeal more to people seeking to tap into a high percentage of their built-up equity. Financial institutions that offer loans and HELOCs typically allow customers to draw as much as 75% to 85% of their existing equity. Meanwhile, most home equity investors usually cap their offers at around 25% to 30%.
That said, home equity investments have many advantages worth considering. They can be especially appealing to homeowners who:
- Don’t want to take on more debt
- Want to use their home equity to get rid of existing debt
- Don’t want to make monthly payments
- Are credit-challenged and don’t like available loan terms
So, What’s the Best Home Equity Option?
In order to determine which approach is right for you, conduct a thorough analysis of your personal situation. Consider how each of the two approaches would play out in your case, while also keeping in mind that home equity investments often conclude with the homeowner selling their home. If you need guidance for your personal situation, then you may want to consult with a licensed financial advisor.