When life hands you a big expense - such as medical debt or education costs - borrowing against the equity in your home can be a smart way to obtain the financing you need at an affordable interest rate. There are two types of second mortgages that allow you to leverage the value of your home: the home equity loan and home equity line of credit (HELOC).
As with any type of financing, both options have benefits and drawbacks. Below is an explanation of how home equity loans and HELOCs work, their pros and cons, and tips for deciding between the two. Armed with this knowledge, you’ll have a clearer picture of which type of second mortgage will work best for you.
What is a home equity loan?
A home equity loan works similarly to your primary mortgage. In this case, you’re given the money in one lump-sum. Then, you pay off the loan over time by making monthly payments at a fixed interest rate. It’s a good choice for covering one-time expenses.
- The fixed monthly payments make it easier to budget.
- Home equity loan rates are often lower than credit cards and other types of loans.
- Home equity loans are secured by your property, meaning that your home could be at risk if you default on the loan.
- In order to take out a home equity loan, you’ll need to pay closing costs and other fees.
What is a home equity line of credit (HELOC)?
In contrast, a home equity line of credit (HELOC) functions more like a credit card than an installment loan. Here, you’ll be able to borrow against your home, as needed, for a set period of time. During that time, you’ll usually only have to make payments on the interest of what you’ve borrowed. After your borrowing period is over, you’ll begin making payments on both the principal and interest of the loan.
- You can borrow money, as needed, up to a certain limit.
- Interest rates on a HELOC are usually lower than credit cards or other loans.
- HELOC rates are typically variable, which makes payments hard to estimate.
- A HELOC is secured by your home, meaning it could be at risk if you default on the loan.
- Your lender may have the ability to freeze or reduce your line of credit if your financial situation changes.
Deciding between the two
Deciding between a home equity loan versus a line of credit typically comes down to two factors: how you’d like to receive the money and how you want to pay off the loan. If you only need to cover a one-time expense, a home equity loan is your best bet. However, if you have ongoing costs, you’ll benefit from the flexibility of a HELOC.
Additionally, if you prefer the certainty of a fixed, monthly payment, a home equity loan is usually the winner. Notably, some lenders do offer the option to convert a HELOC to a fixed-rate after a certain period of time. But, if low payments are most important, consider a HELOC for its interest-only payment period.