Through the years, as they make regular mortgage payments, homeowners will gradually build up their ownership stake in their homes. While this equity will be fully realized upon the selling of the asset, there are ways to access the capital in a house while still living in it, such as through home equity loans and home equity lines of credit (also known as HELOCs). It is important to understand the difference between a home equity loan and a home equity line of credit.
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The use of the equity in a house to secure financing is the common denominator connecting these two types of financial instruments. However, there are significant differences in the way both types of financing are constructed, disbursed, and repaid.
What Is a Home Equity Loan?
A home equity loan is a loan that uses the equity you have built up in your house as collateral. In essence, you are borrowing against the asset you own, and you will be once again paying off the outstanding debt you have on your house. It is for this reason that a home equity loan is often referred to as a second mortgage.
The quantity and terms of the loan will depend on the loan amount you are seeking as well as your financial circumstances, including your credit score. In practice, lenders tend to base the amount of the loan offered on the amount of equity that you own, generally up to 80-85% of the value that is in your possession.
You will begin paying both the interest and principal on the lump sum that you will receive. For most home equity loans, this will be a fixed-rate loan.
Because the underlying asset has tangible value, a home equity loan tends to be easier to qualify for and cheaper for the borrower than a loan that is not secured by a physical asset.
Another advantage: Your interest payments on a home equity loan can be tax deductible if the loan itself is used to make home improvements or repairs. Depending on the project in question, these improvements could even make the home more valuable as well.
What Is a Home Equity Line of Credit?
Similarly to a home equity loan, a HELOC is an arrangement that you enter into with a financial institution that allows you to borrow against the equity you own in your home.
In a standard arrangement, you can gain access to up to 85% of your home equity for a predefined time frame, known as the draw period. The draw period is generally between five to ten years. The sum of money that is agreed upon with the corresponding financial institution becomes a revolving line of credit.
In practice, you will be able to continuously borrow this amount (i.e. you can have this amount outstanding) throughout the draw period. In this way, a HELOC shares some similarities with the way a credit card balance works. As you repay the principal that you owe during the draw period, you will be able to take on additional debt through the HELOC arrangement.
During the draw period, in most cases, you will only be responsible for making interest payments. Once the draw period ends, a repayment period (typically 10-20 years) will commence. You will be responsible for repaying both principal and interest during this timeframe.
In some cases, you can also reduce your tax burden by deducting your interest payments if you use these funds to either materially fix or improve you home.
Which Is Better For You: A Home Equity Loan or a HELOC?
The difference between a home equity loan and a HELOC is akin to the difference between taking on a loan and the potential to access a maximum amount of financing.
A home equity loan is a lump sum of money that you will receive. Once the money gets disbursed into your account, you will be responsible for paying back the entirety of the balance (along with interest) over the lifetime of the loan.
A HELOC gives you the ability to access funds. You will only be responsible for principal and interest payments on the amount of money that you actually decide to withdraw. This option is not free of charge, of course, as there are origination fees and other costs of opening a HELOC that you will owe the financial institution. (In addition, some HELOC arrangements require a minimum withdrawal.)
Deciding which is best for you depends in large part on what you intend on using the funds for. For instance, if you are planning on using the money for a one-time cost such as a home renovation or to get out of credit card debt, a home equity loan might make more sense.
On the other hand, a HELOC might be more appropriate if the monies will be used for a recurring cost, such as regular tuition payments. It might also be a good option if you are not certain of the amount of funds you will need to access. In most cases, the HELOC is essentially an option to access a set amount of funds, and not necessarily an obligation to do so.
Conclusion: Making the Best Decision
Taking on any debt should come with plenty of thought and consideration. You should have a good understanding of what you will use the monies for, as well as a plan to make sure that you are able to repay the debt in full and on time.
Both a home equity loan and a HELOC can help provide you with a cheaper source of financing than an unsecured loan. However, you need to remember that you are leveraging your house in order to access this financing. If you are unable to repay your debts, you could lose your home.
For that reason, it is absolutely essential that you fully committed to both the purpose and the repayment of your obligation prior to agreeing to either of these financial arrangements.
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