Is your money tied up in your home? Are you considering a second mortgage to perhaps consolidate your debt or tackle home renovations? If so, a home equity loan or a home equity line of credit (also known as HELOC)—both secured from your home’s equity—could be right for you.
Now you might be asking, “Which is right for me?” Good question. Here’s a brief explainer that distinguishes a HELOC from a home equity loan.
But first, let’s define “home equity.”
What is Home Equity?
Home equity is your home’s market value minus the amount you still owe on your home.
Let’s say you took out a $250,000 mortgage on your home, and you’ve paid down $100,000. You still owe $150,000 on the principal of your loan. Your family is growing and you’d like to add on to your home, so you have your (well-maintained) home appraised. In this hot market, home values are going up—so it’s not surprising when the appraisal comes back at $300,000.
$300,000 (home value) – $150,000 (what you still owe) = $150,000 (home equity)
It’s safe to say that you probably wouldn’t receive a home equity loan or HELOC for the full amount of your home equity; lenders typically cap around 80% of the total. Assuming they aren’t concerned about your ability to repay the debt, you could be looking at up to $112,500 in loan amount.
Now that we understand home equity, let’s check out the characteristics of a home equity loan and home equity line of credit to determine which one might best suit your situation.
Home Equity Loan
Based on the equity in a borrower’s home, a home equity loan has a fixed interest rate ensuring the payment is consistent each month and will be paid off within a specified term. Interest rates usually range from 3% to 12% and—like with other loans—will depend on your credit score, income, and the lender’s policies, among other factors.
Additionally, with most loans a borrower typically receives the money in one lump sum. A home equity loan can be a good option when you know how much money you need to borrow and what you are going to use it for. If you’re still looking to build that home addition, the predictability and stability of a home equity loan might be a good fit.
Home Equity Line of Credit
Just like a home equity loan, a home equity line of credit (or HELOC) also requires borrowing against your home—but there are some differences. For starters, instead of a lump sum of money, you have access to a pool of money over time.
A HELOC is often compared to a credit card. You can write checks, make charges, or withdraw cash from your credit line. You take what you need when you need it, up to the credit limit on your HELOC. And similar to a credit card, you can make payments in any amount (with a specified minimum, which is typically the accrued interest for the month). This allows you to pay down the debt at whatever pace works for you—keeping in mind, of course, that you will accrue more interest the longer you take.
Speaking of interest, HELOCs typically have a variable interest rate that rises and falls across the term of the loan—with a range anywhere from 3% to 21%. Because of the adjustable interest rate, minimum payment amounts will vary from month to month. The same variables that influence the interest rate for a home equity loan also impact a HELOC.
Taking out a HELOC can be a good option when you don’t necessarily know how much money you will need, or when you will need it. It gives you the flexibility to borrow as much or as little as needed across a long period of time—usually several years.
The Bottom Line
With both a home equity loan and a HELOC, your home is being used as collateral. Borrowers should be certain they can afford the monthly payments, or they risk facing foreclosure. While you’re carefully considering both home loan products, make sure you understand your credit score and that it’s high enough to achieve low interest rates—a critical step on whichever path you choose.