Home equity is the difference between a property's fair market value and the outstanding balance on all of its liens.
Home equity is also an extremely valuable asset that you can borrow against for a variety of purposes.
If you have built a considerable amount of equity in your home, there are two main ways you can use it to your advantage:
- A home equity loan.
- A home equity line of credit (HELOC).
In addition to home repairs and renovations, other common uses include of home equity loans and HELOCs include:
- College tuition.
- Medical expenses.
- Credit card repayment.
- Down payments on vacation homes.
So, how do you know which type of financing is the best fit for you? In this article, we provide a side-by-side comparison of home equity loans and HELOCs to help you answer this question (and a whole lot more).
What is a home equity loan?
A home equity loan is a lump sum payment that a lender makes to a borrower who is using his or her residence as collateral.
Need to access $50,000 from your home’s equity? Upon approval, your lender will spot you $50,000. Plain and simple.
When you take out a home equity loan, you are essentially placing a second mortgage on your property. However, they will typically have much shorter terms than first mortgages. (The same goes for HELOCs.)
Home equity lenders will typically allow you to borrow between 75 to 85 percent of your home’s equity. If you have $200,000 in equity, you may be eligible to borrow between $150,000 to $170,000.
How to repay a home equity loan
When you borrow a home equity loan, you will need to immediately begin repaying it according to:
- The term period.
- The interest rate.
Both the term period and interest rate will be set by the lender.
A traditional home equity loan carries a fixed interest rate. This means you will pay the same rate for the life of the loan.
Like a traditional mortgage, your rate will be determined by several factors, including:
- Current market rates.
- Your existing mortgage balance.
- Your home’s value.
- The length of the loan.
- The loan amount.
- Your credit history.
- Your income.
Interest rates on home equity loans are typically lower than those on HELOCs.
Pros and cons of home equity loans
The primary benefits of a home equity loan are:
- Immediate financing.
- A fixed interest rate.
- Monthly payments that will never change.
However, this also highlights the main downside of home equity loans. You could tap all of the equity in your home at once. This may come back to bite you --- especially if your property value declines.
What is a home equity line of credit?
A HELOC is a convenient, flexible and relatively low-cost way to borrow money for any purpose.
Think of it like a credit card. Your lender will provide a credit limit that you can draw upon. This limit relies on the percentage of equity available in your home. You can borrow as much or as little as you like (up to that maximum). Interest only accumulates when you actually borrow from the credit line. Unlike a home equity loan, a HELOC does not require immediate repayment.
Another difference between the two is that HELOCs typically have adjustable or variable interest rates (though some have recently started offering fixed rates). Because they are subject to change, an increase in market rates will increase the interest you pay on your line of credit.
Some lenders may offer a low introductory rate on a HELOC that increases after a given period. HELOC rates generally adjust monthly or quarterly, depending on the terms specified by the lender.
If you qualify for a HELOC you will have to pay many of the same upfront fees as your regular mortgage, including:
- An application fee.
- Attorney’s fees
- A title search.
- An appraisal.
Under most credit lines, you can borrow up to 75 percent to 85 percent of your home’s value minus your current mortgage balance. If your home is valued at $500,000 and you have $300,000 remaining on the mortgage, you could potentially take out a line of credit of between:
- [(500,000 x 75%) - 300,000] = $75,000
- [(500,000 x 85%) - 300,000] = $125,000
How to repay a HELOC
Typically, a HELOC is divided into two parts:
- The draw period.
- The repayment period.
The draw period is the timeframe during which you can borrow money up to the maximum credit limit established by the lender. This period may last five to 10 years.
Once the draw period ends, the repayment period begins. This timeframe is also be established by the lender. Keep in mind that you only have to repay the funds that you actually borrowed. So if you had a $75,000 credit limit but only borrowed $40,000, you’re just responsible for the $40,000 plus accumulated interest. Repayment periods typically last between 10 and 20 years.
In some cases you can make your interest payments during the draw period. This will lower your monthly payment later on during the repayment period. You can also start making payments on principal immediately after borrowing.
It's worth noting that not all HELOCs have a separate repayment period. In these instances, the entire balance of the loan is due at the end of the draw period. Likely this type of credit line will require minimum payments during the draw period, just like with a credit card.
Similar to a mortgage, you will have to pay the full HELOC loan amount if you sell the home, regardless of how long the repayment period was established.
Pros and cons of HELOCs
The primary benefit of a HELOC is flexibility.
To reiterate, a HELOC gives you the freedom to borrow as much or as little of your maximum credit limit as you want. Better yet, you only pay interest on the amount you choose to access.
A HELOC is more flexible than a home equity loan. The latter requires you to borrow a lump sum at once, whereas a HELOC enables you to borrow only what you need, when you need it.
While this flexible nature certainly looks nice on paper, it also presents greater risk to you as a borrower.
Unlike a fixed rate home equity loan, your monthly payments for a HELOC could dramatically increase at any time due to rising interest rates. You could even end up with a large balloon payment due to how the loan amortizes. This occurs when you need to make a much larger payment at the end of the repayment term to satisfy the loan.
Like a regular mortgage, failure to keep up the payment schedule on a HELOC could result in foreclosure.
Tax considerations for home equity loans and HELOCs
It's important to note there are limitations to the tax deductibility of your second mortgage interest.
Prior to the Tax Cuts and Jobs Act signed in December 2017, interest paid on a HELOC was tax deductible --- regardless of how the funds were used. However, the most recent law eliminated the ability to deduct mortgage interest on a home equity loan or HELOC if the funds are not used to substantially improve the home. For example, if you use a HELOC to pay down credit card debt, you will not be able to deduct the interest payments like previously could.
This is important to understand because you could potentially lose a tax deduction if you, say, consolidate your student loan debt using a HELOC. Sure, student loan debt interest is still tax deductible even under the new tax law. But again, a HELOC is not unless it’s used to make home improvements.
Therefore, if you use a HELOC to consolidate your student loans with other debts, you lose that annual tax deduction. For a complete rundown on this deduction, be sure to consult the tax pro on your advisory team.
While traditional home equity loans and HELOCs serve similar purposes, there are plenty of differences you need to consider. Before applying for either, it's important to understand:
- What each of them can be used for.
- How their interest rates are determined.
- When you will need to repay them.
Building equity is one of the many perks of homeownership. As for how you choose to tap into this asset, well, that's entirely up to you.