Homeownership has its perks. Once you’ve owned your home for a while and made regular payments, you build up equity. If you run into a financial need, you can borrow against your equity using a home equity line of credit or a home equity loan. Let’s dig into what those are and whether they’re right for you.
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What is a Home Equity Line of Credit (HELOC)?
A home equity line of credit (HELOC) offers you a credit line based on your home’s equity. What exactly is equity? Your equity is the value of your home less the balance of your mortgage.
Let’s say you own a home valued at $175,000. You owe $100,000 on your mortgage. That means you have $75,000 in equity in your home ($175,000 – $100,000 = $75,000).
With a HELOC, a lender will look at the amount of equity you have, your income, your credit history and your overall debt. Based on those factors, the lender may approve you for a credit line. Lenders typically don’t allow you to borrow more than 85% of your home’s equity. Based on the example above, the most you would be approved for is $63,750.
A credit line is similar to a credit card so you’re approved for a maximum amount you can withdraw. You don’t have to withdraw it all at once. You can withdraw what you need, when you need it.
Once you borrow, you typically have to make payments, but those payments may be interest-only. You’ll have a set period to borrow funds, which is known as your draw period.
After your draw period ends, you’ll need to start making payments. This is called your repayment period and it may last for 20 years or more.
What You Can Use HELOCs for
You can use a HELOC for any purpose; there are no limitations on how you can spend it. Some common reasons borrowers use a HELOC include:
- Paying for educational expenses: College tuition and books add up and federal student aid, grants and student loans only go so far. You might withdraw from your HELOC each year to make up the shortfall or to help pay for books and other expenses.
- Paying for a big event. Weddings and other large gatherings can get expensive fast. Additionally, you need to pay several vendors different amounts at different times. A HELOC’s flexibility can be a big help.
- Home renovations. If you need to update your home, but you’re not exactly sure how much everything will cost, a HELOC could come in handy.
- Debt consolidation. If you have high-interest credit card debt, a HELOC could be an option to consolidate the debt into one payment with lower interest.
HELOC Pros and Cons
Let’s take a look at the benefits and drawbacks of a HELOC.
- Flexibility: Not all of life’s expenses are fixed. A HELOC offers flexibility so you can borrow just as much as you need when you need it.
- Easy to spend: Your lender may give you checks that you can write against your HELOC or a credit or debit card to access your HELOC. You don’t have to wait for your lender to send a check and for that check to clear.
- Long-term access: You have several years to borrow money from a HELOC, which can come in handy if unforeseen expenses arise (and they usually do).
- Risk: With a HELOC, you’re using your home as collateral. That means that if you don’t repay the HELOC according to the terms of the lender, the lender can foreclose. Think carefully about how much you’re borrowing so you don’t take on unnecessary risk.
- Unpredictable payments: Most HELOCs have a variable interest rate. That means the lender can adjust the rate, which changes your monthly payment. Your monthly payments will also increase when your repayment period starts if you’ve been making interest-only payments.
- Fees: HELOCs come with closing costs, much like your original mortgage. You may have to pay an application fee, title search fee and other fees.
What is a Home Equity Loan?
A home equity loan is similar to a HELOC, in that you’re borrowing against the equity in your home. Unlike a HELOC, you borrow a lump sum of money and then you begin paying it back right away.
As with a HELOC, you can typically borrow up to 85% of the equity in your home. Lenders look at your credit, income and debt when they decide whether to offer you a home equity loan.
Home equity loans typically have a fixed interest rate, which means it always stays the same. The monthly payments also stay the same.
What You Can Use Home Equity Loan for
Much like a HELOC, you can use a home equity loan for any purpose. Some common reasons for taking out a home equity loan include:
- Home renovations: If your home hasn’t been updated for 30 years, it might be time. If you’ve already priced out your renovations, a home equity loan can be a relatively low-interest way to fund those renovations.
- Debt consolidation: If you have high-interest credit card debt, you may be able to consolidate it with a lower interest home equity loan.
You could also use a home equity loan for unexpected medical bills, buying a car, or anything else. Just keep in mind that your home secures the loan, and you may not want to put your home at risk for something you don’t truly need.
Home Equity Loan Pros and Cons
As with any financial product, a home equity loan has its pros and cons. Let’s take a closer look.
- Predictability: You know exactly what you’re getting with a home equity loan. You know how much you’re borrowing, your interest rate and how much monthly payments will be.
- Immediate funds: You receive all the money right away and you can use it however you need to.
- Set loan amount: If you find you need more money, you’d have to take out another home equity loan.
- Risk: As with a HELOC, your lender could foreclose on your home if you don’t keep up with your payments.
- Fees: In most cases, you’ll pay fees like an application fee and appraisal fee.
Choosing Between a HELOC and a Home Equity Loan
Which product is right for you? Ultimately, it’s not a question of 1 product being right and the other being wrong. It’s more about which product is the best fit for you.
A HELOC might be right for you if you:
- Value flexibility
- Aren’t sure how much you’ll need
- Don’t mind variable payments
- Want the ability to borrow multiple times
A home equity loan might be right for you if you:
- Value predictability
- Know exactly how much you’ll need
- Want to know exactly what you’re getting into
- Don’t want to be tempted to borrow more money than you need
Choosing a Lender
Regardless of which product you choose, you want to work with a great lender. How do you choose the best mortgage company? Here are a few factors to keep in mind:
- Responsiveness: Do potential lenders get back to you right away when you have a question? Someone who values your business will get back to you promptly.
- Location: Do you want to work with a local lender? Or do you prefer an online mortgage lender that you can work with from a distance? Both options can work well, depending on your preferences.
- Transparency: Does the lender clearly explain the terms of the HELOC or home equity loan you’re considering? Is the lender patient with your questions? A good lender will make sure you completely understand the terms of your home equity loan or HELOC.
- Reputation: Which lender do your family and friends recommend? Take a look at online reviews of the lender and its rating from the Better Business Bureau. If you’re happy with your mortgage lender, check to see if it offers home equity products.
Contact at least 2 or 3 lenders so you can compare rates and terms. Review each quote carefully, comparing fees and the annual percentage rate (APR). Choose a lender that offers reasonable rates and excellent service.