A Guide to Home Equity Loans and Home Equity Lines of Credit
Are you thinking about obtaining either a home equity loan or a home equity line of credit (HELOC) to purchase something you need or want? If so, you may be wondering which loan you should go with. Is one better than the other?
Both types of loans can be used for many purposes. Just a few include:
- Home renovation projects
- Emergencies
- Debt consolidation
- Starting a business
- College expenses
- Funding a vacation
- Paying medical bills
- Buying a vehicle
While home equity loans and HELOCs do have similarities, there are some important differences you should be aware of. It’s important to understand how each loan works so you can select the best option for your needs.
What is a Home Equity Loan?
With a home equity loan, the equity in your home is used as collateral.
For example, if you have accumulated $50,000 worth of equity in your home from your down payment, monthly mortgage payments, and asset appreciation, you may qualify for a home equity loan of up to $50,000.
Benefits of Home Equity Loans
With a home equity loan, you will receive a lump-sum payment for the amount of the loan. This is an important consideration if you need to make a major purchase, deal with an emergency, or do something else that requires you to have the money up-front.
Home equity loans usually have fixed interest rates that may be lower than what credit cards and other unsecured loans offer. Because you will know in advance what your monthly payments will be, this can help you with budgeting.
Another benefit to consider is that the interest on these loans is tax-deductible. The IRS rules on home equity loan tax deductions change frequently, so be sure to consult with a tax professional if you have any questions before applying.
Cons of Home Equity Loans
If you are still making payments on your home, you will end up with two monthly payments – your mortgage and your home equity loan. This is why home equity loans are sometimes referred to as second mortgages.
Another negative to consider is if you default on a home equity loan. Because you are using your home as collateral, if something happens and you have to stop making payments on your loan, you could lose your home.
With a home equity loan, you will also have a reduction in home equity. If you decide to sell your home, you will have to use the proceeds to pay off both your mortgage and your home equity loan.
What is a Home Equity Line of Credit?
A home equity line of credit (HELOC) is very similar to a home equity loan. Your home is used as collateral with both types of loans.
The primary difference between the two loans is in how you receive the funds. With a home equity loan, you receive the money in a lump sum payment. With a HELOC, however, you are given a line of credit that operates similar to a credit card. You can borrow money as you need it over the life of the loan, and as you repay it, the amount of available credit is replenished.
Benefits of HELOCs
The primary benefit of HELOCs is that they are highly flexible. You can use the available money when you need it instead of receiving a lump sum payment and having to immediately begin making monthly payments. Similar to home equity loans, HELOCs also often have interest rates that are lower than credit cards and other unsecured loans.
Because a HELOC is a line of credit instead of a loan, you never have to draw from it if you don’t want or need to. Because of their flexibility, some people take out HELOCs as a form of protection in case something happens, like an unexpected home repair or a medical expense.
Cons of HELOCs
An important negative of HELOCs to consider is that they usually have variable interest rates. This may make budgeting difficult if interest rates rise sometime in the future.
With a HELOC, the amount of the credit line you are given could be reduced if your credit score decreases or the value of your home declines. This could disrupt your plans for using the line of credit or cause other problems.
Another negative of HELOCs to consider is that you may be allowed to make interest-only payments on the money you borrow while the loan is active. After that, however, you will be required to repay both the principal and interest. Depending on the terms of the loan, a balloon payment may be required.
Which Loan Should You Choose?
Whether you choose a home equity loan or a HELOC mostly depends on how you will be using the money.
If you need a lump-sum payment upfront to pay an unexpected medical bill, for example, a home equity loan may be the better option. This will allow you to receive all of the money you need at once and then repay it over time with fixed monthly payments.
If you need a line of credit that you can periodically draw from, like with a home renovation project that you are completing yourself, a HELOC may be the better choice. With this option, you can obtain money to purchase materials, tools, and other supplies as they are needed.
Tap Into Your Home Equity for a Great Rate
Your home is much more than the place you live - it’s a valuable asset. If you have accumulated equity in your home, you may be able to tap into it with either a home equity loan or a HELOC to get a great interest rate.
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