If you are considering getting a loan on the equity of your home, you will see the terms “equity loan” and “equity line of credit” (or HELOC) almost everywhere.
Either of these can be used to fund large expenses, such as: B. Home renovations that can add value to your home in the long run.
Both are available from lenders, including traditional banks, credit unions, and online lenders. And both are backed or guaranteed by the same asset – your home. This means that in the event you fail to repay, the lender could issue foreclosure.
Comparing home equity loans and HELOCs
While home loans and lines of credit are somewhat similar, there are key differences that make one or the other preferable in a given situation.
|Home loan||Home equity Credit line|
|duration||Up to 30 years||Usually 25 years|
|Paid as||Lump sum||Revolving Credit|
|costs||Up to 5% of the loan amount||Various recurring fees|
|Tax Deductible Interest||Yes sir||Yes sir|
What is a Home Equity Loan?
A home equity loan is a loan against the value of your home that is paid to you in a lump sum. That makes it an attractive option for large, one-time expenses such as B. a new roof or the financing of a large-scale home renovation.
A homeowner can “borrow money from a bank and the equity in their home serves as collateral for the loan,” said Elliott Pepper, a certified financial planner and co-founder of Northbrook Financial, in a previous NextAdvisor article.
Home equity is the current value of your home minus what you owe on your mortgage. If your home is worth $ 400,000 and you have $ 100,000 on your mortgage, you have $ 300,000 in home equity.
The more equity you have in your home, the more you can borrow, usually up to 85% of that equity. The total amount is also affected by other factors, such as: B. How many other debts you have and what your creditworthiness is.
How does a home loan work?
You have to repay the loan over a set period of time, similar to paying off your mortgage: monthly and in fixed installments.
If you opt for a home equity line of credit, make sure there are no prepayment penalties.
Most home equity loans have a term of five to 30 years and have a fixed interest rate. The average home loan interest rate is currently below 6%, according to Bankrate, which shares an owner with NextAdvisor. Make sure, however, that you base your calculations on the annual percentage rate (APR), not the interest rate.
Advantages and disadvantages of a home loan
Interest on home loans, as well as HELOCs, is tax deductible when the funds are used to improve your home materially and the total debt associated with the home – including all other mortgages and / or home loans – does not exceed $ 750,000.
The money you get from a home loan is paid out to you as a lump sum. Remember, this can be an advantage for many but a disadvantage for others. It depends on your spending habits and preferences. However, you can use the money for virtually any purpose – it doesn’t have to be home related.
Home loans have a fixed interest rate that can be beneficial if interest rates are expected to rise. HELOCs, on the other hand, have a variable interest rate. This could be a problem if market rates are rising and directly affect how much you would have to pay back.
Home equity loans come with costs and fees that are similar to those of a standard mortgage. These costs are generally between 2% and 5% of the loan amount; It is possible to get the lender to forego some of the fees, says Pepper. It’s worth asking, especially as lenders know that many people have found themselves in financial need as a result of the coronavirus pandemic.
Another major disadvantage of a home loan is that your home acts as collateral for the loan. If you stop making payments you run the risk of losing your home. If you are paying off your mortgage as well, this is another payment that you now have to make every month as well.
What is a Home Equity Line of Credit?
With a home equity line of credit or HELOC, you are granted a loan up to a predefined maximum amount, similar to a credit card. You can use this loan for expenses such as home renovations or to consolidate higher interest debt. Since the credit line is available over a long period of time – a typical term is 25 years – this is a good way of financing ongoing residential projects; it can also be a source of funding for future needs that may arise.
Quite simply: “A HELOC is a revolving credit line that is secured against the value of the equity in your house,” says Lindsay Martinez, Certified Financial Planner at the financial planning company Xennial Planning.
HELOC interest rates are typically much lower than credit cards, making them an option for people who have high credit card debt and are looking for ways to save on interest payments. (Another way to consolidate debt is to do a balance transfer to a credit card that has an introductory period with no interest on balance transfers.)
How does a HELOC work?
As with a credit card, which is also a revolving line of credit, you can use a HELOC for whatever you need right now. Let’s say you have a HELOC of $ 50,000 and you want to renovate your kitchen, which will cost you $ 20,000. You can take the $ 20,000 off this home equity line of credit and pay it back in regular installments. The other $ 30,000 remains available.
And like a credit card, you can’t go over the credit limit. You don’t have to use everything either and you can pay the remaining amount at any time before the HELOC term expires. You also cannot deduct interest on a HELOC if you use the funds for purposes other than home improvement, e.g. B. Paying credit card debt.
The amount of credit is also affected by the amount of equity in your home; The more equity you have, the larger the line of credit can be. Your creditworthiness and your employment situation are also taken into account.
“Similar to any home loan, there are usually fees involved in opening the HELOC,” says Pepper; these are comparable to the closing costs of a mortgage. These fees can include formation fees, notary fees, title fees, local government enrollment fees, and valuation fees.
The HELOC conditions are also divided into two periods: a draw period and a repayment period. For example, a 25 year credit line can have a draw period of five to 10 years and a repayment period of 10 to 20 years.
The draw period is the time that you can draw on the line of credit; The only payments you will have to make during this period will be interest on the amount you have drawn.
Then the “repayment period” begins, in which you repay the principal plus interest. Most HELOCs have floating rates.
“After the drawing period expires, the outstanding debt will be amortized in accordance with the loan terms,” says Yusuf Abugideiri, Senior Financial Planner at Yeske Buie. Amortization simply means that as a loan ages, more of your payment will be used for the principal and less for the interest. You can also make additional payments to reduce the capital during the drawing.
Advantages and disadvantages of a HELOC
A HELOC acts as a revolving line of credit backed by your home. Since the typical term is 25 years, it can serve as a source of funding for future projects if needed – and this can be a benefit for many homeowners. It is also tax deductible for using the funds to improve your home so long as the total debt related to the home does not exceed $ 750,000.
With a HELOC there are no or only low closing costs, as well as lower up-front costs than with a home loan.
On the other hand, a HELOC may also have ongoing charges associated with it, which may include some or all of the following:
- annual feethat is charged every year, regardless of whether you use the credit or not. This can also be referred to as a membership or maintenance fee;
- Inactivity fee, billed if you do not use the credit line for a certain period of time;
- Early termination fee, will be charged if you close your HELOC before the expiration date;
- Minimum payoutwhich can lead to unwanted interest costs if you don’t need the money right away, says Pepper.
It is possible that at least some or all of these fees may be waived if your lender charges them; it never hurts to ask.
Since a HELOC is a line of credit, you also want to make sure your bills are paid on time – late or missed payments can damage your creditworthiness and even put you at risk of foreclosure.
Note that you cannot sell a home while a HELOC is open as it acts as a lien on the property. Depending on your needs and goals, this can be a significant disadvantage to obtaining a HELOC.
How do you get a HELOC or home equity loan?
The best place to start when looking for a home loan is your bank. Some banks may even require an account with them in order to obtain a home loan. Working with a bank that you are the account holder with can also result in a lower interest rate.
You can apply for a HELOC online from a trusted lender such as US Bank, PNC Bank, or Citibank. Simply enter the required personal and financial information and you can start the application process quickly.
Home equity loans and home equity lines of credit can be used for similar purposes, but they have significant differences. While the former is effectively a second mortgage on your home, the latter is a revolving line of credit; You can think of it as a low-interest credit card, guaranteed by the value of your home.
Once you know what you want to spend the money on, you can make an informed choice between the two.