Home equity loans and home equity lines of credit have become increasingly popular ways to finance large or unexpected expenses. Interest rates are often lower than credit card rates, and both provide access to funds by allowing you to borrow against the equity in your home.
An added benefit is that the interest you pay on the loan may be tax deductible. Talk to your tax advisor to see whether this applies to your situation.
Home equity loans
Also known as a second mortgage, a home equity loan provides access to a lump sum of money that you agree to pay back over 10 to 30 years. An appraisal usually is required as part of the application process to help determine the market value of your home.
Often best suited for large, one-time expenses, home equity loans are beneficial if you need help with expenses like short-term home improvements or a new car. This type of loan typically has a fixed interest rate.
Home equity lines of credit
A home equity line of credit, or HELOC, functions like a revolving line of credit. Rather than receiving a lump sum, you can borrow as much or as little money as you need at any given time – up to your maximum credit limit. When you’re approved for a line of credit, you’ll receive checks or a credit card to use when you want to draw against your line of credit.
A HELOC may be divided into two periods:
- The draw period, during which you can actively use the line of credit
- The repayment period, which is when you pay back the borrowed amount
In most cases, your minimum monthly payments will be only the interest during the draw period. You’ll be responsible for paying back the principal during the repayment period. This could result in a higher monthly payment or a balloon payment at maturity. If you pay on the principal during the draw period, it becomes available for you to borrow again until the draw period expires.
One of the major benefits of a HELOC is its flexibility. Like a home equity loan, a HELOC can be used for anything you want. However, it’s best-suited for long-term, ongoing expenses like home renovations, medical bills or college tuition. The amount you can be approved for is based on a percentage of your home’s appraised value minus what you still owe on your first mortgage.
A HELOC usually has a variable interest rate based on the fluctuations of an index, such as the prime rate.
Understand the terms of the loan or line of credit
When you commit to a home equity loan or line of credit, you’re using your home as collateral. Be sure you understand the terms of the loan or line of credit and only borrow an amount that fits comfortably within your budget.
If you choose a fixed-rate loan, you’ll be on a recurring payment schedule. So you’ll know the exact amount of your monthly payments over the entire term of your loan. With a HELOC, you’ll have the flexibility to make interest-only payments during your draw period.