What is the Difference Between a Home Equity Loan and a Line of Credit (HELOC)?

One of the primary benefits of homeownership is building
equity. This is the value tied up in your home and it increases as you pay down
your mortgage and home values rise. You can find out what your current equity
is by simply subtracting how much you owe from the current market value of your
home. The difference is your equity. It’s a bit like having a savings account
for your home. Except that the value is looked up and can’t be accessed until
your sell or borrow against the equity. Banks will allow you to borrow like
this through either a home equity loan or a home equity line of credit (HELOC).
This can very useful if you need emergency maintenance funds or you want to make
home improvements. But by doing this you’ll be taking on some financial risks.

Borrowing on your equity

What differentiates these two types of loans from a personal
loan is that the house is the collateral. If you can’t keep up with payments,
then you risk going into foreclosure.
Also, these two types of “second mortgages” will draw on your equity and thus
reduce the value of your home. There’s a real chance that you could end up
borrowing more than the home is worth. This is a serious problem if you need to
move and must sell. You’ll either end up losing money on the sale or be unable
to move at all. Most lenders for both loans will cap the amount you can borrow
at 85% of your current equity. Other factors are also considered such as credit
score, income and market value in how much you can borrow.

Both of these loans have their own pros and cons, so it is
essential to choose wisely. Most financial planners will stress that the only
justification for tapping into your equity is to add
value to your home. Consider that as you look at the pros and cons
of both options.

Home equity loans

A home equity loan is one in which the borrower gets a
one-time lump sum. This loan is to be repaid over a fixed term at a fixed
interest rate. Meaning that your monthly payments will be the exact same month
after month, year after year. This makes it easy to account for in your budget.
However, keep in mind you’ll be paying the home equity loan in addition to your
current mortgage payment.

Pros

Great as a source of funds for major projects or
one-time expensesComes at a fixed interest rate over a set period

Cons

Taking one large chunk out of your equity can
work against you if property values decline in your area.



Home equity lines of credit (HELOC)

With a HELOC, you’re given a line of credit which you can
draw on over a set period of time. This makes it much like a credit card. The
beauty of this is that you’ll only be paying interest on what you borrow.
HELOC’s usually start with a lower interest rate than a home equity loan. But
they come with an adjustable
interest rate which will rise or fall depending on the movements of
a benchmark. Meaning your monthly payments will change depending on the
interest rate and how much you have borrowed. Some lenders will allow you to
carve out a portion of your HELOC loan and set it at a fixed rate. You’ll still
be able to draw on the remaining balance at the adjustable rate. Some banks also
offer it in two different forms:

One with an interest-only draw periodOne with a draw period where you pay back
interest and principle.

With the latter option, you can pay back the loan sooner. When
the line of credit expires the repayments on the principal will begin. Once the
outstanding balance and interest are paid back the lender may or may not renew
your line of credit.

Pros

You pay interest only on the amount you’ve
borrowedIt may come with the option of paying only the
interest during the draw period

Cons

An adjustable interest rate makes your monthly
payments unpredictableIf you’re not careful you can overspend and land
yourself with large principle and interest repayments once the repayment period
begins.



So which is better?

The answer to this, as with so much else in real estate, is
that it depends. One will be better than the other depending on your own
personal situation. Think about how much money you’ll need and for what
purpose. Consider monthly payments, interest rates, and tax advantages. If you
need a large amount to cover expenses now and don’t plan on borrowing again, a
home equity loan is better. But if you need cash over a staged period, like for
a modeling project that will take three years to complete, a HELOC is the right
choice.

The equity in your home can provide ready cash for when you
need it. But it will mean taking a risk with a second mortgage that in a worst
case scenario can lead to foreclosure. Different banks will also have different
policies on these loans, so be sure to ask your lender the right questions so
you know what you’re agreeing to. Talk closely with your financial advisor on
the best course of action before deciding.

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