A home equity loan (HEL) or line of credit (HELOC) can be a helpful tool for responsible homeowners. Though there are subtle differences between these two types of loans, they share one fact: the equity in your home serves as collateral.
Equity is the difference between the appraised market value of your home and the remaining principal left on your mortgage. For example, if your home appraises at $500,000 and your current outstanding home loan debt is $200,000, your equity is $300,000.
Home Equity Loan
Once referred to as a second mortgage, a HEL is a second loan in addition to your original home mortgage.
It differs from your original home mortgage because it is for a lesser amount generally at a higher interest rate because it is repaid only after your first mortgage should you default. Most homeowners use a home equity loan to pay for home improvements or repairs, though it can be useful in unexpected, emergency situations.
Just as with your original mortgage, the loan is for a lump-sum amount, which you repay over a fixed period such as 15 or 30 years.
Home Equity Line of Credit
A HELOC, on the other hand, is a revolving line of credit with a set limit similar to a credit card. Like a credit card, the interest rate is variable and you can use as much or as little of the money as needed, up to your assigned limit. To access the HELOC you simply write a check or use a debit card linked to the account.
Keep in mind that even though it differs from an unsecured credit card, it is a secured loan with your home as the collateral, so if you default you could lose your home.
HEL and HELOC Advantages/Disadvantages
If you are considering obtaining a home equity loan or line of credit, be sure you understand the benefits and disadvantages of each.
The advantages of a home equity loan are that you can consolidate your debt or get much-needed home improvement financing and end up with a single fixed monthly payment with an interest rate that is lower than a credit card rate and gain tax benefits at the same time.
The disadvantage of a home equity loan is that sometimes homeowners who slip into financial trouble may believe that this is their way out of debt. Unfortunately, they then fall into the cycle of getting a loan to pay off debt, only to free up credit, so they can make more purchases. This is commonly known in the business as reloading.
The advantages of a home equity line of credit include its flexibility and lower overall cost. Specifically, you only pay when you use it. Additionally, closing costs are lower than with a primary mortgage and interest rates are lower than a credit card. If you itemize your taxes, the interest is deductible for mortgages under $1,000,000.
The disadvantage of a home equity line of credit is the added financial risk you incur against your home. For instance, with outstanding unsecured debt you usually only run the risk of things such as garnishments and collection calls. However, if you use your HELOC to pay off unsecured credit card debt, you turn it into secured debt putting your home at further risk. Additionally, the interest rate on a line of credit is variable and higher than on a HEL, and HELOCs can often be difficult to obtain without a great credit rating. Finally, some lenders require borrowers to take an initial advance upon loan set up, withdraw a minimum amount upon use, and keep a minimum amount always outstanding.
While it is great to have the ability to exercise your flexibility, it is equally important to exercise discipline when you obtain either a home equity loan or a home equity line of credit. Don’t be tempted to risk your home for luxuries, conduct a careful review of your financial situation, and
be sure to shop wisely and find the best interest rate and terms available to you.