Breaking Down the Difference Between a Home Equity Loan and Home Equity Line of Credit
There are a multitude of benefits to being a homeowner, but one benefit that is often overlooked is the ability to leverage the equity in your home for specific financial goals. You can leverage your home’s equity by applying for a home equity loan or a home equity line of credit (HELOC). These are powerful financial tools that have a variety of uses beyond the standard home renovation. However, many are unsure of the difference between a home equity loan and HELOC, and as a result are hesitant to take advantage. We’ve broken down how each of these lending tools works, and which might be better for your unique situation.
Calculating your home’s equity
Both loans work by letting you borrow against the equity you currently have in your home. You can calculate what your equity is with this simple equation:
The value of your property – The amount you owe on your primary mortgage = Your potential equity
Your lender will use this equation, plus your financial history and their specific policies, to calculate how much money they can lend you. Come prepared for the application, which requires much of the same documents as a mortgage application. These could include tax statements, pay stubs. lists of your assets, and the details of the property you hold equity in.
What can I use a home equity loan or HELOC for?
There are so many ways you can put your home’s equity to work. Here are just a few of the ways you can use your loan or line of credit:
- Home repair
- Home renovation
- College tuition
- Debt consolidation
- Medical bills
How does a home equity loan work?
Top benefits:This is a close-ended loan, meaning you borrow a specific amount of money and then pay it back on a fixed interest rate within a certain period of time. It works much like a car loan or a personal loan.
- You know the exact monthly payment, including principal and interest, that is required of you during the loan’s term and can budget accordingly.
- Interest is tax-deductible.
When to use a home equity loan:
Use this loan if you need a singular, lump-sum amount to pay for an up-front, one-time cost like a wedding or home repair. This is also one of the most popular methods to consolidate credit card debt. You can apply for a loan that will pay off all of your high-interest credit card debt, transfer it to a home equity loan with lower interest rates, and pay off your debt that way.
How does a HELOC work?
When to use a HELOC:As a line of credit, this is considered revolving credit, and works much like a credit card. The lender will approve a specific amount of money that becomes your credit limit and will give you a length of time you’re able to utilize that credit. This could be anywhere from 5 to 15 years. You can withdraw money from this credit line when you need it throughout the life of the loan, usually through checks the bank cuts for you. You can repay the borrowed amount with minimum monthly payments that tackle the interest first or make larger payments to pay off both the interest and principal. Once the term of the loan is up, you’ll need to repay all of the credit you’ve used, and can apply for a renewal of the credit line.
You need funds that are staggered out over a longer period of time, or you’re unsure of what the total cost will be. For example, you are paying for your child’s tuition at the beginning of each semester or you’re renovating your home and will need to pay contractors regularly.
- You can withdraw custom amounts as needed.
- You can pay less on interest if you withdraw small amounts and pay them back quickly.
- Interest is tax-deductible.
Important factors to keep in mind
These loans can be thought of as ‘second mortgages,’ as you are drawing upon the value of your home, separate from your first mortgage. You are using your house as collateral for these loans, so if you default, you risk the lender foreclosing upon your home.
Another risk is specific to the line of credit. As it works along the same principles as a credit card, it can be easy to keep withdrawing funds for different purposes without properly maintaining a plan to pay those funds back. If you find you are often tempted to spend erroneously with a credit card, then a line of credit may not be your best choice.
Both the home equity loan and the home equity line of credit are easy ways to leverage your home’s value in order to meet your financial goals. Regardless of the route you choose, stay up to date with our Cents to Save blog to receive more financial insight and advice in the future. Subscribe for free today!