What’s the difference between a home equity loan and a home equity line of credit?
Wouldn’t it be great if you had a gold mine that you could tap into when you needed money? If you’ve owned your home for a while, you may be sitting in a gold mine and not even realize it. Tapping into home equity can be a great way to access money at interest rates that are way better than credit cards.
So how does a home equity loan work and how do you choose the right one for your situation?
The basics of home equity borrowing
The “equity” in your home is what it’s currently worth (market value) minus the amount you owe on your home loan, which is called your “first mortgage”. Equity is built when the value of your home increases and as you decrease the principal amount you owe by making your mortgage payments. So how much equity do you have?
Let’s say the market value of your home is $100,0000, and you owe $55,000 on your first mortgage. Congratulations! You have equity in your home worth $45,000.
So does that mean the entire $45,000 is available to borrow through a home equity loan or line of credit? Probably not, because most lenders allow you to borrow up to 85% to 90% of the current value of your home. For a lender that has an 85% limit, you would be able to borrow $30,000 on top of your home loan. For you math lovers, here’s the formula: ($100,000 x 85%) minus $55,000.
Sound good? Great, now let’s look at the two types of home equity borrowing.
Two types of loans and some common features
There are two ways to borrow against the equity in your home. A home equity loan and a home equity line of credit (HELOC). What do they have in common?
The approval process for both types of home equity borrowing is similar. The bank will look at your credit score and total debt-to-income ratio to make sure you’re not borrowing more than you can afford. You will have to fill out paperwork, and the bank will most likely get an appraisal of your home to make sure the market value is correct. And you’ll be asked to pay fees to apply for and process the loan.
When a home equity loan or HELOC is issued it becomes a “second mortgage” and your home is pledged as collateral. This means if you stop making payments, the lender can foreclose on your property.
Interest you pay on a home equity loan or HELOC can be tax deductible if you itemize deductions and the money you borrow is used to buy, build or improve the home that you use as collateral for the loan.
So what are the main differences between a home equity loan and a HELOC. There are three:
- When you receive money from the loan
- How payments are structured
- How interest rates are determined
Difference #1: When you receive money.
With a home equity loan, you receive money upfront. If you want to borrow $25,000 to fix up your home, for example, the bank will issue payment for the full $25,000 when the home equity loan is issued.
A HELOC is an approved amount that the lender will let you borrow against the equity in your home. If you’re not sure how much money you’ll need or when, you can use checks or a payment card that will draw money from available line of credit funds.
Difference #2: How payments are structured.
Payments on a home equity loan are like your first mortgage. You’ll be given a schedule of monthly interest and principal payments to make based on the term of the loan. Most home equity lines are set for a term between 5 and 20 years.
HELOC payments can be structured two ways. The first lets you make interest-only payments during a set time to “draw” or borrow money on the line of credit. The second requires principal and interest payments during the draw period. In both of these situations, you’ll be required to make interest and principal payments to pay off the line of credit after the draw period ends.
Difference #3: How interest rates are determined.
Home equity loans typically have a fixed interest rate that doesn’t change over the term of the loan. These rates are usually a bit higher than variable-rate loans.
Most HELOC loans have a variable interest rate that is adjusted based on changes in common financial benchmarks - the prime interest rate for example. With some HELOC loans, you can convert the interest rate from variable to fixed.
So what’s the best option?
Choosing between a fixed rate, set amount home equity loan and a variable rate, open line of credit really depends on your situation.
If you need to borrow a fixed amount and don’t see the need to borrow again for a while, a home equity loan gives you a set schedule to pay back the loan.
But if on the other hand, you have a frequent need to borrow smaller amounts and pay those back quickly, the flexibility of a HELOC might be better.
Either way, tapping into the equity in your home can be a great way to fund home improvements, pay off an consolidate high interest credit card debt, or give you peace of mind knowing you can access cash at reasonable rates for emergencies.