The equity in your home increases as you pay down your mortgage and home values rise. To find out how much equity you have, simply subtract how much you owe from the current market value of your house. The difference is what you have in equity. It’s almost like a savings account attached to your home. You can access this value by either selling your house or borrowing against the equity.
Access to cash
The benefit of HELOCs and home equity loans is that they give homeowners easy access to cash. This could be helpful in an emergency or for people who want to make home improvements. In the case of the latter, you’ll be able to deduct the interest paid from your taxes.
Under the Tax Cuts and Jobs Act of 2017, borrowers can deduct the interest paid on HELOCs and home equity loans if they use the funds to buy, build or improve the home that acts as collateral for the loan.
The risks of borrowing against equity
What makes HELOCs and home equity loans different from personal loans is that your house is the collateral. If you can no longer make payments on the loan, then you risk your house going into foreclosure.
Additionally, if you borrow against the equity in your home and home values decrease, you could end up owing more than your home is worth. This can be a problem if you have to move and must sell your home. If you owe more than it’s worth, you could end up losing money on the sale or be unable to move.
Home equity loans and HELOCs — both of which are also called second mortgages — share similarities but are also different.
Similarities between HELOCS and home equity loans
A home equity loan and home equity line of credit (HELOC) are alike in that both are secured by your home, just like the first mortgage you obtained to buy your place. That’s why these loans are commonly referred to as “second mortgages.”
Both loans are usually for shorter terms than first mortgages. Home equity loans and HELOCs are paid off within five to 20 years, while 30 years is typical of a first mortgage.
Home equity loans come with fixed rates while HELOCs are traditionally adjustable-rate loans. However, in recent years, banks have allowed borrowers to convert these loans into fixed rates.
Borrowers must also apply for both loans. Qualifications vary among lenders, but most will check your credit score and debt-to-income ratio.
There are also several differences between home equity loans and HELOCs, and it’s important to understand them if you’re considering an equity loan.
Home equity line of credit (HELOC)
A HELOC works more like a credit card. You’re given a line of credit that’s available for a set time frame, usually up to 10 years. This is called the draw period — during this time, you can withdraw money as you need it.
HELOCs come in two varieties:
- One with an interest-only draw period.
- One with a draw period where you can pay interest and principal.
The latter option helps you pay off the loan faster.
As you pay off the principal, your credit revolves and you can use it again. When a line of credit has expired, you enter the repayment period, which can last up to 20 years. You’ll pay back the outstanding balance that you borrowed, as well as any interest owed. A lender may or may not allow a renewal of the credit line.
Let’s say you have a $10,000 HELOC. You borrow $5,000, then pay back $3,000 toward the principal. You now have $8,000 in available credit. This gives you more flexibility than a fixed-rate home equity loan.
A HELOC has a variable interest rate that is tied to a benchmark interest rate, such as The Wall Street Journal Prime Rate. As the prime rate moves up or down, so does your HELOC rate. Payments will vary depending on the interest rate and how much credit you have used. However, some lenders will allow you to convert an adjustable rate into a fixed rate.
The borrower accesses the line of credit using specially issued checks or a card that looks like a credit card. Lenders often require you to take an initial advance when you set up the loan, withdraw a minimum amount each time you dip into it, and keep a minimum amount outstanding.
Home equity loan
A home equity loan is a term loan in which the borrower gets a one-time lump sum. The loan is repaid over a fixed term, at a fixed interest rate, with equal monthly payments.
Lenders normally cap the amount to 85 percent of the equity in your home. However, other factors like credit score, market value and income also affect the amount of the loan.
Let’s say a lender gives you a $30,000 home equity loan at a fixed rate of 5.69 percent and 10 years to pay it off. Your monthly payments, including principal and interest, are $328.41 every month. Over 10 years, you will pay $9,409.25 in interest, bringing your total payments to $39,409.25.
Interest rates on home equity loans are typically a little lower than they are for HELOCs.
Use Bankrate’s home equity loan rates tables to get the most current rates.
HELOC vs. home equity loan: Which is right for you?
The answer to this question is seldom black and white. But there are some scenarios in which the choice is obvious.
For example, let’s say you need $7,000 to pay for your daughter’s wedding next month and $3,000 to fix your roof, which will take a week. You know exactly how much you need, and both amounts are due in full soon. If you don’t have plans to borrow again, a home equity loan for $10,000 is the way to go.
But if you need money over a staggered period — for example, at the beginning of each semester for the next four years to pay for a child’s college tuition or for a remodeling project that will take three years to finish — a line of credit is ideal. It gives you the flexibility to borrow only the amount you need, when you need it.
And if you borrow relatively small amounts and pay back the principal quickly, a line of credit can cost less than a home equity loan.
Credit card debt consolidation a popular use of home equity
Instead of using a balance transfer credit card, consumers with a lot of credit card debt often will borrow a lump sum and pay off their high-interest accounts. Oftentimes, they’ll save money because the interest rates for home equity loans and HELOCs are lower than those for credit cards. Fixed-rate home equity loans are used more often than HELOCs for this purpose.
Borrowing home equity: Questions to ask yourself
To help you determine which loan best suits your needs, ask yourself:
- When do I need the money?
- For how long do I need the money? Is it for a short-term purpose or long-term need?
- How long do I need to repay the loan?
- What monthly payment can I handle?
- Would a revolving line of credit tempt me to spend the money carelessly?
Questions to ask your lender
Be sure to ask your lender these questions:
- How long is the term of the home equity loan?
- How long do I have to pay it off?
- How long is the draw period and repayment period of a HELOC?
- How large a line of credit do I qualify for?
- Is my line of credit renewable when the loan expires?
- What are the interest rates?
- Do I have to use my credit line right away? (If you’re opening a credit line for future needs or emergencies, you’ll want one that doesn’t require a minimum draw at closing.)
- Under what circumstances can you freeze or reduce my loan, or demand full payment?
- Can I rent out my house during the time of the loan?
- Will you loan to me if my house is on the market (and at what rate)?
- If interest rates go down, how much will my payments drop?