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heloc vs. home equity loan

With homeownership comes home equity. Both home equity loans and home equity lines of credit (HELOCs) use the equity you’ve built up to help you pay off big expenses. You can use these loans to tackle credit card debt, tuition payments or a kitchen renovation. In addition, you can use these loans essentially as another mortgage to pay off debt you owe on your home. You just use your home as collateral and and pay monthly payments with different interest rates on the loan. So in the HELOC vs. home equity loan decision, which is best for you? We explain the nitty-gritty below and let you decide.

Both loans can be instrumental in ridding you of debt you owe on your home or otherwise. But you’ll want to be careful when using them. If your monthly equity payments conflict with your primary mortgage payments and you can’t handle both, you could face foreclosure. However, if you’re prepared to pay monthly interest for both loans, a home equity loan might just be right for you. Read on as we highlight the functions of and differences of a HELOC vs. home equity loan.

How HELOCs Work

For starters, home equity is the original market value of your home minus the loan balances you’ve got left. So it’s basically the percentage of home you fully own. For instance, let’s say you purchased a house at $200,000 with a 20% down payment. You would need a $160,000 mortgage, but you would already have $40,000 in equity.

Home equity often fluctuates throughout the years of monthly mortgage payments. This is because more monthly payments equates to a larger percentage of home you fully own. However, the larger the value of equity, the easier it’ll be for you to completely get rid of those mortgage costs. This is where a home equity line of credit (HELOC) comes in. A HELOC essentially acts as a form of credit. Banks allow you to access the funds provided by a HELOC whenever you need them. However, they also give you a set credit limit you cannot exceed. In addition, HELOCs come with variable interest rates and monthly payments. Lenders might also charge you minimal closing costs, if any at all.

If you’re set on using a HELOC, you’ll have to participate in two different phases of the loan. These are the drawing phase and the repayment phase. The drawing period, which lasts about 10 years, allows you to access credit whenever you need it. The repayment phase, on the other hand, lasts about 10 to 20 years and requires you to pay variable, principal-plus-interest payments until you’ve paid off the loan balance. In some situations, however, you as the borrower may convert your interest rates to a fixed-payment basis.

Advantages of a HELOC

One of the pros of having a HELOC is the flexibility they provide. Though you have to keep the credit limit in mind, you basically get to access your credit whenever you need it. You can do this as long as you take care of your interest payments. In addition, lenders offer a lengthy repayment period, so you should have enough time to pay back the money borrowed. Furthermore, the interest rates fluctuate based on your credit.

How Home Equity Loans Work

heloc vs. home equity loan

Banks and credit unions offer home equity loans to borrowers in one lump sum. In other words, they offer you a specific amount of money and set the time frame in which you must repay it. In addition, home equity loans come with fixed interest rates. Therefore, your interest payments won’t change throughout the duration of the loan, so you’ll know how much to expect to spend each month. However, you’ll still have to pay for your mortgage as you’re repaying your home equity loan.

When it comes to costs, home equity loans typically require loan-processing, loan-origination, appraisal and recording fees. In some cases, lenders may also charge you pre-paid interest, or “points,” at closing time. The pre-paid interest normally equates to 1% of the loan value. The points also lower your interest, which saves you money in the long-term.

Advantages of a Home Equity Loan

In the HELOC vs. home equity loan comparison, it’s important to note that home equity loans are great for one-time expenses. They’re also a great option when you’re dealing with low interest rates for your home. Because both the loan terms and interest rates are set for home equity loans, you could save more money with lower interest rates. Home equity loans have another plus. With them, you know exactly how much you’ll have to pay back and the period of time over which you’ll have to pay it. Having a fixed monthly payment can relieve a bit of financial stress when you’re dealing with other variable costs.

Home Equity Loan vs. Conventional Mortgage

Both home equity loans and traditional mortgages similarly provide homeowners funding by using their homes as collateral. Both loans also mandate that you repay installments over a fixed period of time. However, home equity loans are a bit different from your traditional mortgage. Whereas you take out a traditional mortgage to cover the costs of a new home, you use home equity loans to pay off current housing-related costs. In other words, conventional mortgages are used to purchase a home, while home equity loans are only used after you’ve established equity in your home.

Finally, the two loans also differ due to the interest rates the lenders offer. Because a home equity loan can act as a second mortgage, the lender accepts a higher level of risk. For instance, if the borrower fails to meet the traditional mortgage’s monthly payments, the home goes into foreclosure. If this happens, the home equity loan lender will have to wait until the borrower pays off the first mortgage. It’s only after this that the second lender can earn back the loan money.

HELOC vs. Home Equity Loan

While HELOCs and home equity loans offer low-cost, credit-based funding, the HELOC vs. home equity loan difference hinges largely on the amounts of money and interest rates at which they provide loans. Home equity loans provide lump sum loans, while HELOCs offer set credit limits from which you can withdraw money whenever you need. Furthermore, home equity loans require monthly fixed interest rates. HELOC lenders, on the other hand, charge variable monthly interest rates. But both forms of equity loans function under an already-established mortgage, so keep that in mind when you’re considering using one.

Bottom Line

heloc vs. home equity loan

When considering the HELOC vs. home equity loan match-up, both present clear advantages. They offer a strategic solution for homeowners looking to access funding for additional financial needs. Whether you’re looking to renovate your home to increase its value or pay off other forms of outstanding debt, both loan options provide equity-based funding that you can use to your advantage. These loans also come with fixed and variable interest rates and basically use your home as collateral until you repay the money you borrowed.

Tips on Managing Mortgage Costs

  • Before opening a second mortgage and considering the HELOC vs. home equity loan decision, it’s important to identify your financial situation and whether such an action is feasible. Taking out a home equity loan to cover extra home maintenance expenses could help you knock out many costs in a shorter amount of time than you predicted. But remember to consider the risks that come with paying for two mortgages. Sometimes life takes an unexpected turn, so you’ll want to make sure you’ve got enough financial cushion to prevent foreclosure.
  • If you’re concerned about effectively budgeting your assets when paying for the two different loans, consider seeking expert advice. SmartAsset’s SmartAdvisor matching tool can hep you find the perfect financial advisor for your goals.

Photo credit: ©iStock.com/Vladimir Vladimirov, ©iStock.com/sturti, ©iStock.com/MicroStockHub

Rickie Houston Rickie Houston writes on a variety of personal finance topics for SmartAsset. His expertise includes retirement and banking. Rickie is a Certified Educator in Personal Finance (CEPF®). He graduated from Boston University where he received a bachelor’s degree in journalism. He’s contributed to work published in the Boston Globe and has worked alongside award-winning faculty for the New England Center of Investigative Reporting at Boston University. Rickie also enjoys playing the guitar, traveling abroad and discovering new music. He is originally from Wilmington, North Carolina.
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