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What is a home equity loan?

Home equity loans are financial products that allow a homeowner to borrow against the equity in his or her home. Equity is the difference between how much the home is worth and any debts against the home, such as a mortgage.

Home equity loans are a popular way to pay for big expenses such as a kitchen remodel. Maybe your credit card bills have gotten out of control or your house needs an expensive roof repair. If you need a large amount of cash, you may want to consider borrowing some of the equity you have built up in your home.

Comparing 2 types of home equity debt

Home equity loan Home equity line of credit (HELOC)
Type of interest: Fixed-rate Variable-rate
Repayment term: 5 – 15 years 15 – 20 years
Payout: Lump sum Revolving credit
Type of loan: Secured Secured
Best for: Debt consolidation, major renovation costs Minor renovation costs over a number of years

There are two types of home equity debt: a home equity loan and home equity line of credit, also known as a HELOC. Both are sometimes referred to as second mortgages because they are secured by the borrower’s home, just like the original (or primary) mortgage.

So, what’s the difference, and how does a home equity loan work compared with a HELOC?

“A home equity loan is a fixed-rate installment loan where all the money is borrowed in one lump sum at inception and repaid in even monthly payments (or installments) over the term of the loan,” says Greg McBride, CFA, chief financial analyst for Bankrate.com.

“By contrast, a home equity line of credit has a variable interest rate but offers a great deal of flexibility on both the borrowing and the repayment,” says McBride. “During the initial draw period, typically 10 years, the homeowner can borrow funds only when they’re needed and has discretion over whether to make a minimum interest-only payment or to pay down the balance more aggressively.”

4 reasons to spend home equity

Borrowing home equity can be a good way to access cash quickly, but you should have a good reason for doing so. Using your home as collateral to pay for a fancy vacation is probably not a sound strategy. But spending equity money on improvements that will raise the value of your home is smart.

Top uses of home equity money include:

  1. Make home improvements.
  2. Pay for education.
  3. Pay off credit cards or other higher-interest debts.
  4. Invest the money.

Here’s what you’ll need for a home equity loan or HELOC:

  • Credit score of 620 or higher.
  • Loan-to-value ratio, or LTV, of 80 percent (20 percent equity in your home).
  • A figure for how much you want to borrow, approximately.

There are many differences between home equity loans and home equity lines of credit. But if you’re just beginning to shop around, you can prepare for both.

First, check your credit score. If your credit score is lower than 620, it may be difficult to qualify for a home equity loan. And the minimum credit score for a HELOC is typically higher.

Lenders generally require a minimum LTV of 80 percent, or 20 percent equity in your home. LTV ratios compare the total loan amount with the value of the property being used as collateral. In other words, lenders want to see that you’ve paid down 20 percent of your original mortgage.

Finally, know how much you want to borrow. Even if the numbers aren’t clearly defined, be as precise as possible. Home equity loans and HELOCs are long-term loans that take years to repay. Don’t borrow more than you need.

How does a home equity loan work?

Once you secure a home equity loan, your lender will pay out a single lump sum. You can use the money to finance home renovations, consolidate credit card debt, etc. Once you’ve received your loan, you have to start repaying it. Home equity loans have a fixed interest rate. That means you’ll pay a set amount every month for the term of the loan, whether it’s five years or 15 years. Your interest rate and terms will not change.

How do home equity lines of credit work?

HELOCs are a bit more complicated. There are two phases: a draw period and a repayment period. HELOCs typically come with a variable interest rate, so payment amounts can change from month to month. Once you’ve secured a HELOC, the draw period begins. You’ll be able to draw money as you need it, when you need it. Draw periods last 10 to 15 years. During the draw period, you’ll be making interest-only payments. After the draw period comes the repayment period. During the repayment period, you’re paying principal and any remaining interest. Repayment periods tend to be longer than draw periods — anywhere between 15 and 20 years.

How do I know which loan is right for me?

Will a home equity loan work better for you than a home equity line of credit? To answer that question, consider what you plan to use the money for.

Home equity loans are best for consolidating higher-interest debt, such as credit cards, or making a big-ticket purchase, McBride says, because they aren’t subject to fluctuating interest rates. Your monthly payments remain the same throughout the life of the loan. Eligibility criteria may be stricter for home equity loans. A home equity line of credit, or HELOC, works more like a credit card because it has a revolving balance. This loan is better for someone who has several large payments due over time, like with a big home improvement project. A HELOC allows you to borrow up to a certain amount for the life of the loan — a time limit that is set by the lender. During that time, you can withdraw money as you need it. As you pay off the principal, you can use the credit again. Although a HELOC is more flexible than a home equity loan, you could end up paying steep interest charges because of the variable rate.

Things to consider with home equity loans and HELOCs

With either a home equity loan or a HELOC, you’re pledging your home as collateral, meaning if you miss loan payments or fall too far behind, the lender could end up owning your home. Equity loans and lines of credit often have a repayment period of 15 years, but it can be as short as five or as long as 30 years. Even if you end up selling your house, you have to pay off the balance of the equity loan before the title can be transferred.