December 22nd, 2018 7:39 AM by Jackie A. Graves, President
Home equity loans and home equity lines of credit let you borrow
against the value of your home -- but they work differently. Find out about
both options here.
When your home goes up in value or when you make payments on
your mortgageOpens a New Window. over time, you
build equity in your home. Equity is the value of your mortgaged property minus
the cost of what you owe on the home. For example, if you owe $200,000 on a
home valued at $300,000, you have $100,000 in equity.
There may come a time
when you decide you want to tap into this equity in your home. Doing so may be
helpful to cover emergencies, fund a remodel, pay down high interest debtOpens a New Window.,
or otherwise cover expenses you incur when you need money more than equity in
If you want to tap into your equity, you have two different
options: a home equity loan and a home equity line of credit. These different
financial products have some important similarities, but some big differences
you need to be aware of.
Home equity loans and home equity lines of credit both allow you
to borrow against the value of your house, but only if you have equity in it.
You benefit from gaining
access to cash, and the interest rate on both types of loans tends to be lower
than the rates on personal loansOpens a New Window. or credit cardsOpens a New Window. because
the loan is secured. In both cases, your house is the collateral -- which means
if you don't pay, the lender can foreclose on your home.
Both home equity loans
and home equity lines of credit also require you to qualify for the loan based
on your income and your credit scoreOpens a New Window..
And, lenders will want to appraise your home to determine its value and
typically cap the amount you can borrow so you don't owe more than 85% to 90%
of your home's value (including your existing mortgage and your new loan).
When you take out either
a home equity loan or a home equity line of credit, you also benefit from the
fact your interest may be tax deductible. Under recent changes made
by the Tax Cuts and Jobs Act, you're permitted to deduct interest paid on a
home equity loan or line of credit only if you use the proceeds of the loan to
cover costs of buying, building, or improving the home you're borrowing
against. The home must be your primary or second home in order for you to be
eligible for this tax deduction.
Unfortunately, there's a risk to both types of loans. Not only
do you face the risk of foreclosure if you can't pay, but it's also possible
that by taking equity out of your home, you'll end up owing more than the house
If you decide you need to sell your home for any reason, you'd
have to come up with the money to pay the difference between what your home is
worth and what you owe.
Although there are similarities between home equity loans and
home equity lines of credit -- also called HELOCs -- there are important
The big difference is that when you take out a home equity loan,
you borrow a fixed amount of money for a designated period of time, such as
borrowing $20,000 for five years.
A home equity line of credit, on the other hand, doesn't involve
borrowing a set amount. Instead, you're approved to borrow up to a certain
amount of money which you can draw from over time.
When you take out a home equity loan, the lender appraises your
home to determine how much you can borrow. Your qualifications, including
income and credit score, will also be evaluated to determine the loan amount as
well as the interest rate you'll be charged.
Once you've been approved, you'll be given the entire amount
you're borrowing up front and will then make payments on a fixed schedule over
the loan term. You'll pay the loan back in full over the course of the loan,
with monthly payments based on amount borrowed, term length, and interest rate.
A home equity loan results in predictable payments if you take
out a fixed-rate loan. You'll know exactly what your interest rate is for the
entire duration of the loan, and you'll know exactly what your payments are --
they will not change during the time you're paying the loan back.
With a home equity line of credit, the lender also appraises
your home -- but this time, the goal is to decide how much of a credit line
they'll extend you. The lender will then approve you for a certain amount of
credit, such as a $15,000 line of credit.
Your line of credit can then be used just like a credit card,
but with a lower interest rate. You'll be allowed to borrow up to $15,000 at
any time you want for the duration of the “draw period.” The draw period is the
time limit when the credit is available to you. You'll have to pay back
whatever you borrowed by the time the draw period comes to an end.
While you're in your draw period and your line of credit is
available, you can borrow as much as you want up to the credit limit. And, once
you've paid back what you borrowed, you can borrow again. For example, if you
had a $15,000 line of credit, borrowed $10,000 and then paid back $4,000, you'd
have $9,000 available to you.
The interest rate you'll pay on your line of credit is typically
a variable rate, which is tied to a financial index. This means your payments
can change based on fluctuations in interest rates. Your payments will be based
on the rate as well as how much you've borrowed at the time.
There are two different ways your payment amount could be
calculated: either you pay interest only on amounts borrowed during the draw
period or payments are based on both principal and interest. With the later
option, your payments are higher, but you pay off the loan faster and don't pay
as much in interest.
You can access your line of credit using a card or checks, but
there may be a minimum borrowing limit depending upon your lender. And, at the
end of the draw period, you'll have to pay the entire loan back.
If you know how much you want to borrow and need the money up
front, a home equity loan is usually the best choice because you'll have the
certainty of knowing what repayment will involve. Typically, interest rates are
also a little lower on home equity loans than home equity lines of credit.
But, if you want to have a line of credit available to you that
you can draw from as needed over time, a home equity line of credit is the
right financial product for you.
Ultimately, you need to consider your situation and your goals
for the money when deciding how to borrow against your home. But, always
remember to borrow responsibly with either a home equity loan or a home equity
line of credit because you're putting your home at risk.
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