For many people, their home is their largest asset. And its value generally grows over time, producing more equity for the homeowners. How can homeowners make use of this equity without selling their house? A home equity loan or a Home Equity Line of Credit (HELOC) are both popular options with different pros and cons.
Home Equity Loan
A home equity loan is a second mortgage that is structured very similar to a traditional mortgage. The amount of the loan will be based on the owner’s existing equity in the home as well as by income and credit history. If all the right factors are in place, owners can often borrow up to 85% of their home equity.
The home equity loan amount will be given to the borrower in one lump sum payment, making it a good option for large purchases or projects like a kitchen renovation or a pool, or for life expenses like paying for a wedding or college tuition. (Borrowers should be cautious though about pulling out a huge chunk of equity for things that do not add value to their homes. That type of behavior put a lot of homeowners deeply underwater during the housing market crisis.)
One nice feature of a home equity loan is that it usually has a fixed interest rate for the life of the loan. The monthly payment will be constant until it is paid off. However, borrowers should be aware that they will be making this payment in addition to their monthly mortgage payment.
A home equity line of credit works more like a credit card account than a standard bank loan. You will be able to borrow up to a certain amount of your equity just like with a home equity loan, but instead of getting a one-time lump sum, a HELOC allows you to pull out smaller amounts as you need it and you only pay interest on the amount you have pulled out. This is a great option for projects like a large home renovation that may last several months. Eventually the draw period will end though and borrowers will no longer be able to pull out money and must start repaying the entire loan.
HELOCs typically come with adjustable interest rates, meaning that the payment can vary based on the trends of other market rates. This can be a dangerous situation if the rate jumps significantly and you can no longer afford the payments.
It is important to understand that both HELOCs and home equity loans are second mortgages, using the property as collateral. That means that if the borrower is unable to repay the loan, the lender could go after the property to recover losses. This can sometimes end in foreclosure. Borrowers should only take out as much equity as they truly need and make a plan to repay it on time.
While different, both home equity loans and HELOCs can help homeowners achieve their goals as long as they use them wisely.