If you need to borrow money, you have a few options to consider. You can take out a personal loan, apply for a credit card, or look for ways to borrow against wealth you already have, such as the equity built up in your home.
If you’re looking to pay lower borrowing costs, a home equity line of credit (HELOC) or home equity loan allows you to get a loan backed by your house, although this option is mostly geared to consumers who owe a lot less than their homes are worth. Most home equity loans and HELOCs allow you to borrow up to 85 percent or 90 percent of the value of your home — and typically with low interest rates and fair terms since you’re using your home as collateral for the loan.
To find out how much home equity you have and how much you can borrow, subtract the amount you still owe on your mortgage from the value of your house. The difference is the amount of home equity you’ve accrued, and part of that amount can be used as collateral for a loan.
Borrowing against the value of your home can be a low-cost way to finance a new addition to the house, replace an old roof or consolidate high interest debt. However, one potential drawback is the fact that, in some cases, these loans can charge closing costs and fees similar to a standard mortgage. You also run the risk of losing your home if you default on the loan, since your home is the collateral. Before you settle on a home equity loan or HELOC, you should shop around to find an option with the lowest fees — or no fees if possible.
On a positive note, the Tax Cuts and Jobs Act of 2017 made it so borrowers can still 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.
What is a home equity loan?
Home equity loans let you borrow against the equity in your home with a fixed interest rate and fixed monthly payment.
These loans are funded in a lump sum, making them similar to personal loans. With the fixed interest rate and fixed monthly payment you get with a home equity loan, you’ll also have a fixed payoff schedule and an exact date when you’ll become debt-free.
While options vary from lender to lender, home equity loans usually come with terms of five to 30 years. During this time, you’ll never have to worry about rising interest rates since your payment will never change.
How can you use the money you receive from a home equity loan? It’s really up to you. Some consumers use it to pay for major repairs or renovations, such as adding a new room, gutting and remodeling a kitchen, or updating a bathroom. Another common use is taking out a home equity loan with a low, fixed rate to pay off high-interest credit card debt.
“A fixed-rate home equity loan is best for debt consolidation, rather than the variable rate and open-ended home equity line of credit,” says Greg McBride, CFA, Bankrate chief financial analyst.
Pros of home equity loans:
- Secure a low, fixed interest rate, fixed monthly payment and fixed repayment schedule.
- Borrow a lump sum you can use for any purchase you want.
- Some home equity loans, including those offered by Discover, don’t have any fees.
- Loan interest may be tax-deductible if used to remodel or improve your home.
Cons of home equity loans:
- The best home equity loan rates and terms go to consumers with good or excellent credit.
- You need a lot of home equity to qualify.
What is a HELOC?
A HELOC, or home equity line of credit, is a line of credit that works similar to a credit card. With this loan, you can borrow up to a specific limit of your home equity and repay the funds slowly over time.
HELOCs typically have a draw period, or a period of time in which you can access the money. That’s followed by a repayment period where borrowing must cease and monthly principal and interest payments are required. With a 30-year HELOC, for example, you may be able to borrow against the equity in your home for up to 10 years before repaying all monies you owe, plus interest and fees, for the final 20 years of the loan. Note that, even though the initial period of your HELOC is called a draw period, you’ll still be required to make minimum monthly payments during that time.
Borrowers can delay repayment in some cases or repay interest only during the draw period, and they can borrow as much or as little as they need just like a credit card. They can pay it back at the monthly minimum or in larger lump sums depending on their needs.
Another similarity to credit cards it the fact that HELOCs tend to come with variable APRs, meaning your interest rate could go up or down based on market trends. The interest rate for HELOCs is determined by several criteria, including rate decisions by the Federal Reserve, investor demand for Treasury notes and bonds, and market forces in the banking industry.
Due to the variable interest rate and the fact you can tap the funds on your own timetable instead of getting it all upfront in a lump sum, this option may be better for consumers who aren’t 100 percent sure how much cash they need.
“A home equity line of credit is better-suited to home improvement projects that will be incurred in stages, or for college tuition payments that will be paid over time, rather than the lump-sum home equity loan,” McBride says.
Pros of HELOCs:
- Only borrow as much money as you need.
- Many HELOCs, including options from Bank of America, come without any fees.
- Repayment options can be flexible.
- You may be able to deduct the interest on your HELOC on your taxes if you use the funds to improve your home.
Cons of HELOCs:
- Variable interest rate that can change with the whims of the market.
- You need considerable equity to qualify.
Home equity loans vs. HELOCs
Trying to decide between a home equity loan or a HELOC? Since both let you borrow against the equity in your home and may come with low rates and fees (or no fees), it can be difficult to decide. The following chart lays out how each loan option works and the most important factors to consider.
|Home equity loans||HELOCs|
|Interest rate||Fixed and may be as low as 4.24%||Variable and may be as low as 5.4%|
|How funds are disbursed||Lump sum||Borrow as needed|
|Monthly payments||Fixed payment for the life of the loan||Payment depends on how much you borrow, rate level|
|Closing costs||Varies depending on lender||Varies depending on lender|
|How to apply||Apply online||Apply online|
Best ways to use a home equity loan or HELOC
The proceeds of a home equity loan or a HELOC can be used to pay down high-interest debt, including any credit card debt you have. Since the average credit card interest rate is currently over 17 percent, it’s not too difficult to see how consolidating debt with a HELOC or home equity loan could help you save money or get out of debt faster.
Another benefit of using home equity to consolidate debt is the fact that you can often go from having to make multiple payments each month down to just one. In other words, you could save money by consolidating and simplify your financial life by reducing the number of bills you pay each month.
In addition to debt consolidation, you could lean on home equity to complete a major home remodeling project, pay for major home repairs or even fund college tuition. Since you can use funds from a home equity loan or HELOC however you want, it’s really up to you.
Just remember that using your home as collateral for a loan does come with risk. If you were unable to make the monthly payments, you could lose your home to foreclosure.
Another risk comes into play if the value of your home declines and you need to sell. In that case, you could end up owing more money than what your home is worth, or be “upside down” on the loan at the worst possible time.
How to choose between a home equity loan or HELOC
Still can’t decide between a home equity loan or a HELOC? Both options can be good ones, but one option is probably better for your needs.
As you continue researching loans, it can help you shop around for quotes for both HELOCs and home equity loans to see which one might offer a lower interest rate, low fees and better terms. Also consider these scenarios where a specific option might leave you better off:
A home equity loan could be better if:
- You know the cost of your project and need to borrow a lump sum of money.
- You prefer a fixed interest rate that will never change.
- A fixed monthly payment you can count on fits well into your lifestyle.
- You want to consolidate high-interest credit card debt at a lower interest rate and pay it off with a fixed repayment plan.
A HELOC could be better if:
- You want the ability to borrow as little or as much as you want — when you want.
- You have upcoming expenses like college tuition and don’t want to borrow until you’re ready.
You don’t mind if your payment fluctuates.