Home equity is an asset that you can borrow against for a variety of purposes. And when used correctly, it can be extremely valuable.

The two most common ways to leverage this asset are with:

  • A home equity loan.
  • A home equity line of credit (HELOC).

When you take out one of these loans, you are essentially placing a second mortgage on your home. However, both loans typically have much shorter terms than first mortgages.

Both home equity loans and HELOCs allow you to access funds for a variety of purposes. In addition to home improvement projects, other common uses include:

  • College funding.
  • Credit card repayment.
  • Medical expenses.

Home equity lenders will typically allow you to borrow between 75 to 85 percent of your home’s equity. So if you have $200,000 in equity, you may be eligible to borrow between $150,000 to $170,000.

But before you do, let's hash out the various differences between home equity loans and HELOCs.

How home equity loans and HELOCs work

A home equity loan provides a lump sum payment to the borrower. If you want to borrow $50,000 from your home’s equity, the lender will write you a check for $50,000.

On the other hand, a HELOC is similar to a credit card. The lender will provide a maximum credit limit you can draw upon. This limit relies on the percentage of equity available in your home. You can borrow as much or as little 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.

How to repay home equity loans and HELOCs

You will immediately begin repaying a home equity loan based on:

  • The term period.
  • The interest rate.

Both are set by the lender.

Meanwhile, a HELOC is divided into two parts:

  • The draw period.
  • The repayment period.

During the draw period, you may borrow funds up to the maximum limit established by the lender. This typically lasts five to 10 years from the time the HELOC is established.

During the repayment period, you must pay back the funds you borrowed plus interest. Repayment periods typically last between 10 and 20 years.

In some cases you can make your interest payments during the draw period. This leaves you a lower monthly payment during the repayment period. You can also start making payments on principal immediately after borrowing.

How you pay interest on home equity loans and HELOCs

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 with a traditional mortgage, the rate relies on 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 on HELOCs.

Meanwhile, HELOCs typically have adjustable or variable rates that are subject to change. That means an increase in market rates will increase the interest you pay on your line of credit.

Some lenders may also offer a low introductory rate that will increase after a given period. HELOC rates generally adjust monthly or quarterly, depending on the terms specified by the lender.

Pros and cons of home equity loans

The primary of benefits of a home equity loan include:

  • A fixed interest rate.
  • Monthly payments that will never change.

The main downside of a traditional home equity loan is that you could tap all of the equity in your home at once. This can work against you if your property value declines.

Pros and cons of HELOCs

The primary benefit of a HELOC is flexibility. Upon approval, you have the option to only borrow the amount you need. Plus, you will only pay interest on the amount you actually borrow.

The main downside of a HELOC is risk.

  • Your monthly payments could increase at any time due to rising interest rates.
  • You could also end up with a large balloon payment. This occurs when you need to make a much larger payment at the end of the repayment term to satisfy the loan. If your variable interest rate rises over the loan period, this adds to the cost of the credit line.

It's important to note there are limitations to the tax deductibility of your second mortgage interest.

In December 2017, Congress passed the Tax Cuts and Jobs Act. The law eliminated the ability to deduct mortgage interest on a home equity loan of HELOC if the funds are not used to substantially improve the home.

For example, if you take a home equity loan to pay down credit card debt, you will not be able to deduct the interest payments starting this year. For a complete rundown on this deduction, be sure to consult a tax expert.

Key takeaways

While traditional home equity loans and HELOCs serve similar purposes, they have plenty of differences. Before applying for either, it's important to understand:

  • How they work.
  • How you repay them.
  • How interest is determined.

Building equity is one of the many perks of homeownership you can use to finance major life events. How you choose to tap into this asset is entirely up to you.

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