If you want to tap into the equity in your home, you have two options: home equity loan or home equity line of credit. While they sound similar, they have several differences. Understanding how they work, what their differences are and when the loan over the line of credit makes more sense can help you make the right choice.
What is a Home Equity Loan?
A home equity loan is similar to your first mortgage. You apply for a set amount and receive it in one lump sum. You usually pay a fixed interest rate and have a short period to pay it off. You do not have the option to reuse the funds. Once the money is gone, it is gone. Just like with any other mortgage, you use your home as collateral. You can usually borrow up to 85% of the value of your home, but each bank has a different home equity program they offer.
What is a Home Equity Line of Credit?
The home equity line of credit is also a second mortgage. You tap into your home equity, usually up to 85% of the value of the home. With this loan, however, you can reuse the funds. It works like a credit card. You have a credit limit. You draw the funds and use them as you see fit. During the first ten years, you pay only interest on the funds you withdrew. After the first ten years, the line closes – you cannot use the funds any longer. At this point, you pay both principal and interest over the next 20 years to pay the loan off. The interest rate is variable on this loan.
Choosing Between the Two Loans
The two loans may sound pretty similar at this point. When you decide between the two, you must consider your future plans. Why do you need the funds? Will you have another need after you pay them off? Are you finically disciplined? These answers play a role in choosing the right loan for you.
Paying One Time Expenses
One scenario where a home equity loan makes more sense than a line of credit is when you have a large debt to pay off or large expense to pay. Let’s say you have a loan with a very high interest rate or you need to pay off a very large medical bill. These are one-time expenses. A home equity loan will provide you with the necessary funds to pay the loan off and then you pay the money back one month at a time. Using this method does not give you access to the funds in the future, which can protect you from spending money you don’t need to spend. If you used a HELOC, you could pay the money back and then use it again if you are within the draw period. This never allows you to gain back the equity in your home.
If you are in debt, you are not alone. A majority of Americans are in the same position. If you want to lower your internet rates and consolidate everything into one loan, consider the home equity loan. Again, it provides you with funds one time. The lender can write the checks directly to your debtors. In some cases, they have to do it this way to ensure that your debt ratio decreases enough for the program. Once the loan pays off your debts, you have one loan to pay – the second mortgage. Because you cannot access the funds again, you cannot rack up more debt. Of course, you must stay disciplined in this situation because you used the equity in your home. If you were to rack up credit card debt again, you would basically double pay for your debts as you pay off the mortgage and the credit cards at the same time. Have a plan in place to eliminate the risk of credit card use to protect yourself.
Paying for a College Education
Student loans often have very high interest rates. If you have the equity in your home, you may be better off borrowing from your own money. With the lower interest rate, the college education costs you less. However, keep in mind, a second mortgage could take 20 to 30 years to pay off. If you will retire soon, you may not want anything touching the equity in your home. Consider your long-term plans to see how this loan would affect your situation. If you know you will sell the home in the next few years, you may want to leave the equity untouched, otherwise you have less money to purchase another home for your golden years.
Satisfying Short-Term Needs for Funds
There are situations where you might need money for the short-term. Generally, if you do not see a need to have access to ongoing funds, the home equity loan is the better choice. A home equity line of credit is just too tempting. Knowing that you have access to $20,000, for example, opens up too many possibilities for spending. You may start looking around your house and thinking of things you would love to change or you may take a luxurious vacation you otherwise could not afford. If you have a short-term need for funds, take out the loan and pay it off. This way you solve the problem without opening up problems for future financial issues.
Paying the Loan Off Over the Long-Term
Consider your financial situation when you borrow the funds. For example, if you know affording the payments will be difficult, you may want the satisfaction of the fixed interest rate on a home equity loan. If, however, you know your need for money is temporary and you have the ability to pay the loan off in a few short years, you can save a little money with a HELOC. The interest rates may be lower because they are variable. But there is a large risk if you know it will take you the entire term to pay the funds off, which is when the loan makes more sense than the line of credit.
As with any loan, consider all of your options. Don’t look only at the interest rate of each loan, though. Consider the costs of obtaining the funds and the long-term effects of the loan. A home equity loan takes the equity out of your home, just as a HELOC does. If you need that equity in the near future, you may want other options. However, if you plan to stay in the home for the long-term, compare your options. Consider the long-term effects of a variable interest rate versus a fixed rate and determine what you can afford. Once you decide on the home equity mortgage, shop around with different lenders to find the best program and interest rate for you.