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Both home equity loans and home equity lines of credit allow you to tap your home’s equity and get cash for any purpose. Each comes with its own pros, cons, and risks to be aware of. (iStock)
Home equity is the difference between what you owe on your mortgage and what your home is worth. You gain home equity as you pay down the principal balance of your mortgage and when your home value increases.
Home equity loans and home equity lines of credit are common ways to tap your home equity. Each has its pros and cons, and comes with risks. Here’s a quick guide to help you decide when one might be better for your needs.
What is a home equity loan?
A home equity loan, also known as a second mortgage, lets you keep your existing mortgage but take out a second new loan against your home’s equity in a one-time event. You repay the loan with equal monthly payments over a fixed term.
You can usually borrow up to 85% of the equity in your home through a home equity loan. For example, if your home is currently worth $400,000 and your current mortgage balance is $300,000, you have $100,000 of equity in the home and could borrow up to $85,000 (85% of $100,000) with a home equity loan.
You can learn about current mortgage rates, and get information on another equity-tapping product — a cash-out refinance — by visiting Credible.
What is a home equity line of credit?
A home equity line of credit, or HELOC, is similar to a home equity loan in that you keep your existing mortgage and borrow against your home’s equity. However, HELOCs are revolving credit that allow you to draw funds repeatedly, up to the credit limit, over a term known as the "draw period." You then pay back the loan over another term known as the "repayment period."
Most lenders limit the amount you can borrow under a HELOC to 85% of the appraised value of your home, less the amount you owe on your existing mortgage. If your home is worth $400,000 and your current mortgage balance is $300,000, you could get a home equity line of credit up to $40,000 ($400,000 x 85% = $340,000 - $300,000 = $40,000).
Home equity loan vs. HELOC: What’s the difference?
Both home equity loans and home equity lines of credit allow you to borrow against the value of your home, but there are a few key differences.
Fixed interest rates vs. variable interest rates
Interest rates on home equity loans are typically fixed, so if interest rates rise during your loan term, your payments are not affected.
HELOCs typically have variable interest rates. When interest rates rise, your HELOC’s interest rate, and thus your monthly payment, also increases.
Disbursement: lump sum vs. as-needed withdrawals
With a home equity loan, you borrow a specific amount in a lump sum and repay the loan with regular monthly payments over a fixed term.
A HELOC gives you more flexibility in the amount you borrow and when. Like a credit card, you have a line of credit that you can draw on repeatedly during the draw period, and you only pay interest on the amount currently in use.
Repayment: fixed payment vs. variable monthly payment
With a fixed-rate home equity loan, your monthly payment is based on the full amount of the loan. The loan’s term typically ranges from five to 30 years. During that time, you make equal monthly payments that include both principal and interest.
HELOC payments, on the other hand, can change from month to month. Because most HELOCs have variable rates, your interest rate can fluctuate over the life of the loan. In addition, your payment is based on the amount you’re currently using. For example, if you have a $20,000 HELOC but only withdraw $10,000, you’ll only pay interest on that $10,000 currently in use.
Advantages and disadvantages of home equity loans
Like any credit, home equity loans have their advantages and disadvantages. Consider the following before borrowing against your home’s equity:
Pros of home equity loans
Fixed interest rates: One benefit of a home equity loan is the fixed rate. Even if interest rates rise, your monthly payment won’t go up because your interest rate stays the same.
Flexible use of funds: Lenders generally allow borrowers to use the funds for any purpose. Once you’re approved, you can use a home equity loan to pay for home improvement projects, debt consolidation, buy an investment, pay for education expenses and other uses.
Possible tax benefits: When you use a home equity loan to make improvements to the property securing the loan, the interest may be tax-deductible. Keep in mind, you must itemize deductions to benefit, and your deduction is limited to interest on up to $750,000 of debt, including your first mortgage.
Cons of home equity loans
Two mortgage payments: Unless you’ve already paid off your first mortgage, taking out a home equity loan will give you a second mortgage payment to juggle each month.
Higher interest rate than a HELOC: You’ll likely pay a premium to have a stable rate. Rates on home equity loans are generally higher than the initial rates available for HELOCs.
Closing costs: Like other home loans, home equity loans come with closing costs and fees, which average anywhere from 2% to 5% of the loan amount. Your lender may be able to roll these into your loan so you don’t have to come up with cash at closing, but they increase your total cost of borrowing.
You can read about closing costs at Credible, where you can also learn about current mortgage interest rates.
Advantages and disadvantages of HELOCs
Home equity lines of credit also have advantages and disadvantages. Consider the following pros and cons before tapping your home equity with a HELOC:
Pros of HELOCs
Lower initial interest rate: HELOCs come with lower interest rates than a credit card or personal loan, and they also typically offer lower initial interest rates than home equity loans. Keep in mind, though, a HELOC’s APR can rise if interest rates rise.
Borrowing and repayment flexibility: You may have a $30,000 HELOC, but only need $5,000 this month to replace your furnace. Next month, you may need $10,000 to repair the roof. With a HELOC, you can tap your line of credit as you need it, and repay even as you continue to borrow. Each time you draw on your line of credit, your payment is based on the amount outstanding.
Possible credit benefits: The mix of credit types on your credit report is a factor in determining your credit score. Adding a HELOC to your existing credit usage could expand the range of credit types you use — and have a positive effect on your credit score.
Cons of HELOCs
Continuing costs: HELOCs come with many of the same upfront closing costs as a home equity loan, but lenders may also charge fees throughout the life of the credit line. According to the FTC, these ongoing costs can include an annual membership or participation fee and a transaction fee every time you borrow money.
Variable interest rate: With an adjustable-rate HELOC, your rate can go up or down based on market fluctuations. Even if your HELOC offers a low initial rate, depending on economic factors, you could face higher rates once you get to the repayment period.
Risk of overspending: Managing a HELOC can require some self-discipline, since it’s very easy to access and spend from a HELOC. If you’re not careful, you could find yourself maxing out your spending limit and facing hefty interest charges when the repayment period begins.
Home equity loan vs. HELOC: Which is better?
Which home equity product is better for you — loan or line of credit — depends on your needs and specific situation.
If you need a large sum of money for a one-time event and want the stability of a fixed rate, a home equity loan could be the way to go. However, if you want to tap your home equity in smaller increments spread out over several years, and don’t mind some uncertainty in your interest rate, a HELOC may be your choice.
When to tap home equity — and when not to
Whether you choose a HELOC or home equity loan, avoid tapping your home’s equity to pay for things that aren’t a necessity, such as taking a vacation or buying a boat. Both home equity loans and HELOCs use your home as collateral, so if you run into financial troubles and can’t make your monthly payments, you risk losing your home.
Likewise, it’s a good idea to avoid using home equity to cover purchases that will lose value faster than you can pay off the loan. For example, if you use a 30-year home equity loan or line of credit to buy a car, the car may need to be replaced in five to 10 years. However, you may be paying off the debt used to purchase it for several more years.
What you should know about home equity
You might want to tap into your home’s equity for many reasons, but before applying for a home equity loan or HELOC, consider how long you plan to stay in your home. If you can’t pay off the loan or line of credit before your sale date, you could wind up walking away with less profit, or even none, from the sale after paying off your mortgages and closing costs.
When deciding between a home equity loan vs. HELOC, be sure to shop around with different lenders to compare interest rates and fees. Ask a lot of questions to ensure you’re getting the right financial product for you at the best possible rate.
Credible can’t help you find a HELOC or home equity loan, but it can help you compare offers for a cash-out refinance — another option for tapping equity.