Thinking of tapping the equity in your home to do a renovation, buy a second home, or consolidate debt? Home equity loans and lines of credit are two options you’ll want to explore. Before you decide which borrowing option is right for you, it’s important to understand the main differences between the two.
Home Equity Loan
Home Equity Line of Credit (HELOC)
Fixed interest rate for the life of the loan
Variable interest rate over the life of the loan
Repayment in regular installments over a specific period of time
Option to re-borrow as loan is paid, up to approved credit limit
Typically used for single large purchase, such as a car
Typically used to fund ongoing expenses, such as home renovations, borrowing only as needed
Entire amount of loan received upon approval
Checks can be written at any time, up to approved limit
Both types of credit are sometimes referred to as “second mortgages,” because, like your first mortgage, they are secured by your property.
Home equity loans are fixed, installment loans. They work more like a mortgage — you borrow a determined amount for a specific term with a fixed rate of interest. Regular installment payments are made each month for a set amount. Once you receive the lump sum check, you cannot borrow additional funds.
HELOCs are revolving, borrow-as you-go arrangements. They act more like a credit card in that you borrow as you need the money and pay off your balance according to the interest rate being charged, which is variable, and the amount of credit you have used. The term of the credit line is determined by the lender and may be extended/renewed at the lender’s discretion. When the term expires, the credit line must be paid in full.
Keep in mind that Janet Yellen, chairman of the Federal Reserve Bank, has already announced that she intends to let interest rates rise before the end of the year. Although most economists expect that rising interest rates will be gradual, it is inevitable after such a long stretch of historically low interest rates. What this means for a variable-interest loan like the HELOC is that the payments you are making now will probably go higher in the future.
Both home equity loans and HELOCs must be settled with the lender if and when you sell your home.
Match the Type of Loan to Your Need
Generally the choice between the two types of credit depends on your intended use for the money and your time frame for repayment. For instance, if you have a set amount in mind for a specific expense – a wedding, a new septic system or roof — and you have no further foreseeable expenses, then a fixed rate home equity loan makes sense. If however, your needs are more open-ended — a major home renovation that will span a year or two, or to supplement a child’s college tuition each year for the next four years — then the more flexible HELOC could be the better option.
Used for Debt Management
Perhaps one of the most popular reasons homeowners tap into the equity in their homes via a loan or a line of credit is to consolidate credit card debt. While recent conditions in the housing market may have deterred some from considering this option, generally speaking, home equity is one of the lowest cost loan options, and unlike credit card debt, the interest paid on home equity loans and HELOCs is tax deductible.
To learn more about tapping home equity or to access current rate tables, one consumer-oriented website, bankrate.com may be a useful reference for you.