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Wondering if a Home Equity Loan or Line of Credit makes sense for you? Read on to learn the difference between a Loan and Line of Credit, learn how these loan programs work, how to choose which is right for you and some important pitfalls to avoid!
Home Equity Loans and Lines of Credit
Your home equity is the percentage of your home that you own—the home’s value minus the amount you owe on your mortgage. If you’ve paid down your mortgage over time or your home has appreciated since you bought it, you may have a good amount of equity. You can use this equity to your advantage if you’re in need of cash by taking out a home equity loan or a home equity line of credit (HELOC). Before you tap into your equity, learn the differences between your two options and how to avoid running into common pitfalls.
When you take out a home equity loan, you are essentially getting a second mortgage. You’ll borrow money from a lender using your home as collateral, just as you did for the first mortgage. Most lenders will not allow you to borrow more than 75 or 80 percent of a home’s total value, and they include your mortgage in that calculation. This means that, if you only have 20 percent equity in your home, you may not be able to take out a home equity loan. However, keep in mind that you may be building equity even if you’re not paying down your mortgage principle, as long as your house is appreciating.
Because a home equity loan is similar to a mortgage, you will get a lump sum from your lender and pay it back in equal monthly installments on an amortization schedule with a fixed interest rate. Interest rates for home equity loans are typically higher than for mortgages because of the increased risk, though they are lower than most credit card rates. The loan term is generally shorter though (often between 10 and 15 years), so you’ll pay less interest over time than you would for a mortgage. Home equity loans are attractive to many homeowners because the interest you pay is tax deductible (up to $100,000), just like your mortgage interest.
A home equity line of credit shares many features in common with a home equity loan, such as the borrowing limits and tax advantages. The main difference is that a HELOC is a form of revolving credit, like a credit card—you may even be issued a credit card to use when drawing from your HELOC. Your HELOC is broken into two periods, the draw period and the repayment period. In the draw period, which usually lasts about five to 10 years, you can use the line of credit as you wish. If you reach your limit, you’ll have to pay some of it back before you can use it again (just as you would with a credit card). Otherwise, you’ll only make interest payments during the draw period. Once the draw period is complete, you may have the option to extend it, or you may move into the repayment period, which is when you make regular monthly payments on your borrowed money. This period typically lasts between 10 and 20 years, depending on the terms of your loan. Alternatively, your payment plan may be structured with interest-only payments followed by a balloon payment. One main difference between a HELOC and a home equity loan is that the interest rate for a HELOC can be variable, often starting low and climbing higher.
For both types of loans, you can spend the borrowed money on anything you’d like. They’re commonly used for remodeling, because home improvements add value to your home, thus increasing your equity. Many borrowers also use the money to fund their child’s college education, to purchase a second home as an investment or even to consolidate their other debts (since the interest will become tax-deductible). Technically, you can even use the money to go on an extravagant vacation or to buy expensive consumer goods.
As a rule of thumb, you’d usually take out a home equity loan if you needed all of the money at once—such as for a home improvement project for which you’ve already received estimated costs from a contractor. If you’ll need money in installments, as you would if you were using it to finance an education, a HELOC is the way to go. You should also consider current interest rates and how you think they’ll be over the course of your loan, because you’re choosing between a fixed rate and a variable rate. And make sure to calculate how much you can afford to pay back in monthly installments and at the end of the loan’s term. A HELOC may be a riskier loan because of the variable interest rate, but it can also be preferable for those who don’t necessarily need to use all of the money they’re borrowing. The flexibility in having a revolving credit account is appealing to many homeowners, especially if taken out as a precaution or instead of an emergency fund. Whichever option you decide on, it’s important to do your homework, research your choices and shop around for adequate lenders as you did when you took out your mortgage.
As with any loan you take out, you’ll pay interest and closing costs or other fees, so it’s important to make sure the benefits are worth the added expenses. Additionally, some loans have a prepayment penalty, and HELOCs often have a minimum withdrawal amount that you’ll be penalized for not meeting. This is something to keep in mind if you are planning to use a HELOC as an emergency fund.
Generally, homeowners are working toward increasing their home equity, but with these loans you’d be decreasing your equity, which can be risky. If you sell your home while you have a home equity loan or HELOC taken out, you must repay the loans immediately upon selling. Additionally, if you default on either loan, the bank can take your house from you.
What you plan to use the loan money on is important when considering whether to take out a home equity loan or HELOC. If you’re using it to make improvements on your house, take time to first consider how much the improvements will increase the home’s value, and if that is enough of an increase to offset the loan costs. Consolidating credit card debt with home equity can be a prudent strategy because of the tax benefits and lower interest rates, but it can also be risky, especially if you end up accumulating more credit card debt in the future. It’s generally not a good idea to use home equity to purchase luxury items, vacations, everyday expenses or things that depreciate—the interest payments make these purchases even more expensive, and you have the added risk of losing your home. The best use of home equity money is for making sound investments—increasing your home’s value, investing in education, etc.
After you make the decision to borrow equity from your home, you can make an informed decision between a home equity loan and a HELOC. As long as you are careful, you can use your home as both shelter and a source of cash.
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