In a perfect world, you wouldn’t have to borrow any money because you’d always have enough. In reality, there are times when you don’t have the cash for your child’s tuition bill or your own student loan payments. If getting into more credit card debt doesn’t appeal to you, tapping into your home’s equity and opening a line of credit might.
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Home Equity Line of Credit vs. Home Equity Loan
What is a home equity line of credit and how does it differ from a home equity loan? For starters, it’s important to understand the meaning of home equity. It’s the value of your home minus the amount you still owe on your mortgage.
If you buy a $250,000 house and with a 20% down payment, you need a $200,000 mortgage loan. The $50,000 you contribute is your home equity. That’s how much stake you have in your home. As you repay the money you borrowed for your mortgage, your home equity rises. And as you build equity over time, you can borrow against it when you need extra cash.
If you choose to go for a regular home equity loan, you’re agreeing to get a second mortgage and pay the same amount of money (and interest) every month. Usually you’ll be able to secure a loan equal to up to 85% of your home’s equity. Of course, how much you’ll qualify for will be based on your home’s worth, your credit score and the level of risk you potentially pose to a lender.
With a home equity line of credit (HELOC), having your mortgage will seem like having an extra credit card. That’s because you’ll be given a set credit limit with interest rates that change monthly based on your credit and the value of whatever public index is tied to the HELOC. And over the life of the loan, you’ll be allowed to use the money whenever you need it by writing a check or swiping a credit card. Instead of getting one lump sum loan you’ll have a credit line you can tap into in different amounts at different times.
Which Type of Loan Is Best for Me?
Instead of 30 years, you’ll usually have between five and 15 years to pay off either type of loan, depending on its terms. You receive funds all at once when you have a home equity loan. Getting this type of mortgage could be a good idea if you know how much money you want to borrow and you’re using it to cover a short-term, one-time cost. For example, maybe you’re planning to throw your daughter a huge sweet 16 birthday party. If you set your budget at $6,000, you could take out a home equity loan just for that occasion (though if you can save the money first and avoid taking out the loan you can save yourself from having to pay interest).
But if you’ll need the loan for a longer period of time, it may be better to apply for a home equity line of credit. HELOCs are frequently used to pay for college education, debt consolidation and medical expenses. A HELOC could also work if you’re renovating your entire home over the course of a couple of years. In fact, you might be able to get away with paying less through a HELOC than you would under a traditional home equity loan if you only use a little bit of the money each month and pay off your balance in a timely fashion.
Home Equity Line of Credit Rates
Much like with a standard home equity loan, you could be eligible for a HELOC worth up to 85% of the equity in your home. Since the interest rate on the loan is adjustable, you might start out paying less interest than you would through a fixed-rate home equity loan. That could change over time, especially if your initial rate was a special discount.
Rates will depend on your credit history. If you’re trying to get a HELOC or even a home equity loan with bad credit, you may have to bring along additional financial documentation to prove that you’re capable of making payments. Shopping around and comparing quotes from multiple lenders could be one way to find someone willing to approve you for a HELOC. Keep in mind that your house is used as collatoral, so while you may qualify for a line of credit, if you don’t pay it back the bank could foreclose on your home.
A low credit score also means less favorable conditions, such as higher interest rates. That means you’ll pay more than someone with better credit over the long term. A lender can lower or freeze your original line of credit as well. This can happen if a lender doesn’t think you can afford to pay it back any longer.
Additional HELOC Costs to Consider
Besides interest, you’ll be responsible for paying for appraisals and closing costs ranging from attorney’s fees to origination fees. These fees can be negotiable. If you do your research, you can come prepared to negotiate.
Don’t forget that your home equity line of credit is tax deductible if the loan amount is below $100,000. That rule applies to home equity loans too. So if you can’t decide whether you need a HELOC, the tax benefit could be a good reason to get one.
The Bottom Line
Don’t forget you have to pay back your loan at the end of the term. While the HELOC might help you afford to pay your bills, you have to be careful. You could fall into a debt trap if your mortgage lender renews your line of credit and you continue to use that extra money.
Reloading can get you into trouble as well. In other words, if you’re using the loan to pay off another lender and you continue spending money and adding on more debt, you might find yourself on a downward spiral.
What’s worse is that failing to make payments on your HELOC could eventually cost you your home. Before you sign up for another mortgage, it’s best to read the loan’s fine print and think critically about how a temporary HELOC will affect you in the long run.
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