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Looking to borrow against the equity in your home? Maybe you have heard the terms home equity loan and home equity line of credit (HELOC) before and wondered what the difference really is. This article will compare the two types of borrowing and take you through the pros and cons of each one.
Home equity loan vs. HELOC: What’s the difference?
Home equity loan. With a home equity loan, you borrow a lump sum of cash using the value in your home as collateral. The loan will have a fixed schedule for repayment, usually lasting between 5 and 15 years. They often have a fixed interest rate as well, though adjustable rate versions are available.
HELOC. A home equity line of credit, or HELOC, is an ongoing line of credit that’s backed by your home’s equity — think of it a bit like a credit card. Your bank will authorize a certain dollar amount (similar to a credit card’s credit limit) and period of time during which you can access the line of credit, known as the draw period. Within this time, you borrow only what you need as you need it, though some banks do set a minimum withdrawal. You can make interest-only payments only on the amount you choose to borrow or pay more to start contributing towards the principle.
Next comes the repayment period, where you can’t take out any new funds and need to start repaying the amount you’ve borrowed, if you have not already. Interest rates on HELOCs are variable and often pegged to the prime interest rate.
Comparing home equity loans and lines of credit
Home equity loan
Fixed, but sometimes variable
Withdraw funds as needed
Varies, based on how much you withdraw and interest rate at the time
Fixed for the life of the loan
Yes, but not always
The two types of borrowing do have two major things in common: They are backed by the equity in your home, and there are no restrictions on what you can do with the cash.
With both home equity loans and HELOCs, the maximum amount you can borrow varies depending on your credit and the lender, but generally tops out at 80% to 95% of the your home equity. To calculate your home equity, start with the valueof your house (from an appraisal, if available) and subtract the amount remaining on your loan. You can also use LendingTree’s home equity calculator to estimate how much you can borrow. (Disclosure: LendingTree is the parent company of MagnifyMoney.)
Since the loans are backed by your home equity, the interest rates are usually lower than for unsecured forms of credit like credit cards or personal loans.
It’s up to you what you do with the money from either type of loan. You can make improvements to your home, pay for a vacation or put your kids through college.
However, Brett Anderson, a certified financial planner and president of St. Croix Advisors, said it’s important to think carefully about borrowing against your home equity, which is likely one of your largest assets.
“Remember these are loans that need to be paid back. A home equity loan isn’t free money, even with these low interest rates,” he said.
Tax changes’ impact home equity loans and HELOCs
New laws have changed tax deductions related to home equity loans and HELOCs. From the 2018 tax year until 2026, the IRS says borrowers cannot deduct interest payments on these types of loans, “unless they are used to buy, build or substantially improve the taxpayer’s home that secures the loan.”
In addition, starting in 2018, taxpayers may only deduct interest on $750,000 of qualified loans, or $375,000 for a married taxpayer filing separately. If you have a HELOC or a home equity loan and a regular mortgage, this limit applies to the combined amount of both loans. This limit is lower than it was previously.
So for example, if you take a $100,000 home equity loan and spend $75,000 on a kitchen renovation and $25,000 paying off credit card debt, only 75% of your interest payments is tax-deductible.
Randy Key, home loan specialist at Churchill Mortgage, told MagnifyMoney he’s seen interest in home equity loans and HELOCs drop after the tax changes.
Benefits and risks of a home equity loan
Given the current economic environment of rising interest rates, one of the main benefits of a home equity loan is having a fixed interest rate for the term of the loan — you get a lump sum upfront and have the same steady payment, even if the Federal Reserve continues to hike rates. That makes a home equity loan easier to budget for, said Anderson.
A home equity loan does have some drawbacks. If you already have a mortgage, you’ll have to keep track of two loans and make two seperate payments every month. A home equity loan also has the same sort of closing costs as a regular mortgage. Those costs can take their toll, especially if you aren’t looking to borrow that much money, Key said.
The rate the lender offers you for a home equity loan depends on your credit score. If your score is under 700, you’ll pay a higher rate to compensate for the risk the bank feels it’s taking on, Key said.
Benefits and risks of a HELOC
A big advantage of a HELOC is the flexibility. You get to withdraw the cash when you need it and only pay interest on the amount you use — however, be aware that most lenders require a minimum withdrawal at the closing.
HELOCs can have lower upfront costs than home equity loans, with some lenders offering to pay for closing costs. Key said if you are willing to base your line of credit off the tax appraisal value of your house, most lenders will do a HELOC without a new appraisal.
The major downside of HELOCs is that they use a variable interest rate pegged to the prime rate, which is set to go even higher this year. This means if you have a HELOC, your interest payments are going to get bigger. You’ll also need a strong credit score to qualify; according to Key, a score around 650 is often required, though it depends on the lender.
Equifax data shows that interest in HELOCs is going down, which Key attributed to both the tax changes and the rising interest rates. He said many of his customers are choosing to refinance to combine an existing first mortgage with a HELOC into one loan.
“With a rising rate market, people are seeing that HELOC rate could be 1% higher next year and thinking, ‘I have to do something about this,’” he said.
Which loan type is right for you?
When choosing between a HELOC or a home equity loan, experts say it is important to consider why you need the money: Is it a set project or a variable need?
Going with a home equity loan instead of a line of credit is usually the best choice to pay for a specific plan, like remodeling a kitchen or buying a vacation house.
“[If] you have a purpose for these dollars today, and you know the amount you’ll need, a home equity loan might be a better alternative,” Anderson said.
A HELOC is generally a better choice if you need some added cash but not a fixed amount or fixed timeline. Key recommends them for customers looking to cover “a tight month in the budget or maybe they are investors who want to be able to tap money quickly.”
The third option: a cash-out refinance
If you are considering a home equity loan or a HELOC, you might want to look at a third option: a cash-out refinance.
A cash-out refinance is designed to improve on the terms of an existing mortgage and provide additional cash at the same time. You’ll be refinancing and taking equity out your home at the same time, leading to one new loan with a larger balance than your previous one.
A cash-out refinance is a good option if you need money and at the same time want to improve the terms of your current mortgage by securing a better interest rate or converting an adjustable-rate mortgage to a fixed-rate one. But be mindful of the fees involved, which can be high depending on the circumstances.
Key has recommended these to a lot of borrowers at the moment who need big chunk of cash for a project like a renovation or putting a pool. With interest rates heading higher, he said, if a borrower needs $100,000 to $300,000, “a HELOC is not a good place to park that much in debt.”
Any decision to borrow against the equity in your home should not be taken lightly. The overall volume of both home equity loans and HELOCs has declined since the 2008 financial crisis, when falling property prices burned some borrowers who had borrowed too much against the equity of their homes.
If you need cash and choose to use your home as collateral, a home equity loan is generally the best choice for financing a project with a set cost. A HELOC provides more flexible access to money, but rising interest rates will make these a more expensive choice in the coming year. It’s also worth considering a cash-out refinance, which could potentially improve the terms of your current mortgage while also giving you extra cash to spend.
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