Home equity loans and home equity lines of credit let you borrow against the value of your home -- but they work differently. Find out about both options here.
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When your home goes up in value or when you make payments on your mortgage over time, you build equity in your home. Equity is the value of your mortgaged property minus the cost of what you owe on the home. For example, if you owe $200,000 on a home valued at $300,000, you have $100,000 in equity.
There may come a time when you decide you want to tap into this equity in your home. Doing so may be helpful to cover emergencies, fund a remodel, pay down high interest debt, or otherwise cover expenses you incur when you need money more than equity in your home.
If you want to tap into your equity, you have two different options: a home equity loan and a home equity line of credit. These different financial products have some important similarities, but some big differences you need to be aware of.
What home equity loans and home equity lines of credit have in common
Home equity loans and home equity lines of credit both allow you to borrow against the value of your house, but only if you have equity in it.
You benefit from gaining access to cash, and the interest rate on both types of loans tends to be lower than the rates on personal loans or credit cards because the loan is secured. In both cases, your house is the collateral -- which means if you don't pay, the lender can foreclose on your home.
Both home equity loans and home equity lines of credit also require you to qualify for the loan based on your income and your credit score. And, lenders will want to appraise your home to determine its value and typically cap the amount you can borrow so you don't owe more than 85% to 90% of your home's value (including your existing mortgage and your new loan).
When you take out either a home equity loan or a home equity line of credit, you also benefit from the fact your interest may be tax deductible. Under recent changes made by the Tax Cuts and Jobs Act, you're permitted to deduct interest paid on a home equity loan or line of credit only if you use the proceeds of the loan to cover costs of buying, building, or improving the home you're borrowing against. The home must be your primary or second home in order for you to be eligible for this tax deduction.
Unfortunately, there's a risk to both types of loans. Not only do you face the risk of foreclosure if you can't pay, but it's also possible that by taking equity out of your home, you'll end up owing more than the house is worth.
If you decide you need to sell your home for any reason, you'd have to come up with the money to pay the difference between what your home is worth and what you owe.
How home equity loans and lines of credit differ
Although there are similarities between home equity loans and home equity lines of credit -- also called HELOCs -- there are important differences too.
The big difference is that when you take out a home equity loan, you borrow a fixed amount of money for a designated period of time, such as borrowing $20,000 for five years.
A home equity line of credit, on the other hand, doesn't involve borrowing a set amount. Instead, you're approved to borrow up to a certain amount of money which you can draw from over time.
How a home equity loan works
When you take out a home equity loan, the lender appraises your home to determine how much you can borrow. Your qualifications, including income and credit score, will also be evaluated to determine the loan amount as well as the interest rate you'll be charged.
Once you've been approved, you'll be given the entire amount you're borrowing up front and will then make payments on a fixed schedule over the loan term. You'll pay the loan back in full over the course of the loan, with monthly payments based on amount borrowed, term length, and interest rate.
A home equity loan results in predictable payments if you take out a fixed-rate loan. You'll know exactly what your interest rate is for the entire duration of the loan, and you'll know exactly what your payments are -- they will not change during the time you're paying the loan back.
How a home equity line of credit works
With a home equity line of credit, the lender also appraises your home -- but this time, the goal is to decide how much of a credit line they'll extend you. The lender will then approve you for a certain amount of credit, such as a $15,000 line of credit.
Your line of credit can then be used just like a credit card, but with a lower interest rate. You'll be allowed to borrow up to $15,000 at any time you want for the duration of the “draw period.” The draw period is the time limit when the credit is available to you. You'll have to pay back whatever you borrowed by the time the draw period comes to an end.
While you're in your draw period and your line of credit is available, you can borrow as much as you want up to the credit limit. And, once you've paid back what you borrowed, you can borrow again. For example, if you had a $15,000 line of credit, borrowed $10,000 and then paid back $4,000, you'd have $9,000 available to you.
The interest rate you'll pay on your line of credit is typically a variable rate, which is tied to a financial index. This means your payments can change based on fluctuations in interest rates. Your payments will be based on the rate as well as how much you've borrowed at the time.
There are two different ways your payment amount could be calculated: either you pay interest only on amounts borrowed during the draw period or payments are based on both principal and interest. With the later option, your payments are higher, but you pay off the loan faster and don't pay as much in interest.
You can access your line of credit using a card or checks, but there may be a minimum borrowing limit depending upon your lender. And, at the end of the draw period, you'll have to pay the entire loan back.
Is a home equity loan or a home equity line of credit right for you?
If you know how much you want to borrow and need the money up front, a home equity loan is usually the best choice because you'll have the certainty of knowing what repayment will involve. Typically, interest rates are also a little lower on home equity loans than home equity lines of credit.
But, if you want to have a line of credit available to you that you can draw from as needed over time, a home equity line of credit is the right financial product for you.
Ultimately, you need to consider your situation and your goals for the money when deciding how to borrow against your home. But, always remember to borrow responsibly with either a home equity loan or a home equity line of credit because you're putting your home at risk.