When you want to cash in on your home's value without selling it, you may consider getting either a home equity loan or a home equity line of credit (HELOC).
But how do you know which option is right for you? And what are the differences between these similar-sounding mortgage products?
Here's a primer on the differences between home equity loans and home equity lines of credit — along with the pitfalls of each, and when it's typically best to use one over the other.
In a nutshell, a home equity loan or a HELOC is based on the the current value of your home minus any outstanding loans plus the new one you're getting.
When you add them both together — the first mortgage + the second mortgage — that creates the loan-to-value (LTV) ratio. A lender typically won't exceed 80 percent of the home's appraised value, based on most bank guidelines for a home equity loan or a HELOC. But some banks may go as high as 85 or 90 percent LTV on either a HELOC or a home equity loan.
The basics of home equity loans
A home equity loan is often called a second mortgage because, like your primary mortgage, it's secured by your property — but it's second in line for payoff in case of default. The loan itself is a lump sum, and once you get the funds, you can't borrow any more from that home equity loan.
Since you receive money in a lump sum, these loans are most suitable when you need cash all at once, or for a specific one-time event, such as paying for a wedding, financing major home renovations or getting rid of other obligations such as high interest rate credit-card debt.
One benefit of a home equity loan is that it usually carries a fixed interest rate, making your monthly payments highly predictable. That's important if you're living on a fixed income or want to know precisely what your mortgage repayment will be for the life of the loan.
Home equity loans are also fully amortized loans, so you'll always be repaying both principal and interest, unlike home equity lines of credit that let you make interest-only payments. With interest-only loans, you will face higher payments when you must pay down the principal as well.
Home equity lines of credit, or HELOCs
HELOCs typically have fewer up-front costs than home equity loans. But there are fees. For example, Chase charges a loan origination fee, as well as an annual fee of $50 for these loans. Most banks also charge appraisal fees to verify the market value of a home. A home equity line of credit also differs in the way that funds are disbursed to you. Instead of providing you with a lump sum as with a home equity loan, a HELOC lets you access the equity in your home on an as-needed basis, up to the full amount of your credit line.
So if you have a HELOC, you simply write a check or draw down on your home equity using a credit card issued by your mortgage lender.
You also pay back a HELOC differently. With a HELOC, there are two phases: a draw period and then a repayment period.
If you secure a home equity line of credit on Feb. 1, 2015, and you have a 10-year draw period, you'll be able to borrow from the credit line until 2025.
After Feb. 1, 2025, your repayment period begins and you're no longer able to borrow funds. During the repayment term, which can be anywhere from five to 20 years, you'll repay your lender the principal amount still outstanding as well as interest on the remaining funds borrowed.
Because of how HELOCs are structured, they can provide much more borrowing flexibility than home equity loans, some experts say.
At Citibank, for instance, borrowers can access line of credit funds for five years (the draw period) and then they have a 20-year loan repayment term.
"One advantage of the HELOC is that, just like with a credit card, you're only paying interest on what you've used," says Jeffrey Lorsch, president of Evergreen State Mortgage, a mortgage broker firm in Washington state.
Some HELOC lenders mandate that you take at least a minimum draw upon obtaining the loan. Other HELOC lenders require you to tap a set minimum amount of your home equity each time you write a check from your equity line of credit.
Even though a HELOC gives you great flexibility and ease of access, those features can be detrimental for the wrong borrowers. It's all too easy to get tempted to borrow against your home equity. If you use your home equity line of credit as a piggy bank, before you know it, you've overextended yourself.
It's also a bad idea to use a HELOC without first thinking about the time frame of your financial needs.
In Lorsch's opinion, HELOCs are best used to fund short-term needs -— "12 to 15 months maximum," he says, because their rates, which are tied to the prime rate, can move very quickly. "So in an increasing rate environment, you need to be careful with HELOCs," Lorsch says.
Though it's not likely, Lorsch says that in a worst-case scenario, even a HELOC with a 3 percent to 5 percent rate could shoot up to as much as 18 percent. So he cautions borrowers: "Ask yourself if your budget could handle that."
Foreclosure and taxes
With both home equity loans and HELOCs, your home is collateral for the loan. If you don't pay your primary loan or your equity loan, a lender could foreclose and seize the property.
Although you may have heard that the interest on home equity loans and HELOCs is usually tax deductible on loans up to $100,000, that's not quite the full picture. In truth, the interest you pay on a mortgage up to $1 million is tax deductible. If you have a home equity loan, that overall mortgage limit gets bumped up by $100,000 to $1.1 million, according to Rob Seltzer, a CPA who runs a firm bearing his name in Los Angeles.
So you might have a high-value property — worth, say, $650,000 — and you may have a $250,000 first mortgage on it and a $200,000 line of credit as well. Under this scenario, you'd have $450,000 in mortgage debt outstanding, and because you're well under the $1.1 million mortgage limit, the interest you pay on both loans would be tax deductible, Seltzer notes.
Watch out for the lure of minimum payments
If you decide to tap your home equity in order to consolidate debt, recognize the pros and cons of doing so.
"Home equity is a great tool if it's used responsibly," says Seltzer, "but it can also be a trap."
People looking to consolidate debt, such as credit cards or auto loans, benefit in two ways: "With home equity loans and HELOCs, you're not only getting a lower rate, you're also making payments that are tax deductible."
The downside, however, is that equity lines of credit only require you to pay interest in the early years of the loan. "People need to have discipline and not just essentially make minimum payments on HELOCs," he says.
Lorsch agrees, noting that's another way in which HELOCs can act like credit cards.
"During the first five or 10 years, during the draw period, most lenders only require you to pay interest, and many people do in fact only pay interest, not principal on HELOCs," Lorsch says. "But you can always pay more."
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