Home equity loans and home equity lines of credit (HELOCs) are both viable ways for homeowners with substantial equity to get quick cash when they need it. But it's important to understand how these loans work before you agree to anything. If you end up borrowing more than you pay back, you risk losing the roof over your head.
Here's a closer look at the differences between home equity loans and HELOCs, and how to decide whether one of these is a good fit for your situation.
Home equity loans
A home equity loan is essentially a second mortgage. You're borrowing against the equity you've already built up in your home in exchange for a lump-sum payment. Most lenders will enable you to borrow up to 85% of the total value of the home, but the catch is, you can only borrow from what you already own. So if the home in question costs $100,000 and it's completely paid off, you could borrow up to $85,000. But if you've only paid off half of it, the most you could borrow would be 85% of your equity or $42,500. Other factors come into play as well, like your credit score. Lenders may be hesitant to give you that much money if they're afraid you won't pay it back.
These types of loans come with a fixed interest rate and a term that usually varies from 5 to 20 years. You pay a set amount each month in addition to your regular mortgage payment until the total loan is paid off. If you fail to pay back the money, the bank is within its rights to foreclose upon the home.
A home equity loan makes sense if you have a large, one-time expense like a home remodeling project. It's also a good choice if you prefer to have a predictable monthly payment that you can budget for, rather than one that will fluctuate, like a HELOC. The downside of going with a home equity loan is that if the home values in your area drop suddenly, you could end up owing more than your home is worth, and even selling it may not be enough to pay back the remaining balance.
If home costs have been declining in your area, you may want to avoid a home equity loan or only borrow a small amount that you know you can pay back quickly.
A HELOC is similar to a home equity loan, except you're given a line of credit that you can borrow up to, rather than a lump sum. You don't have to borrow up to the full amount, and you will only be charged interest on the amount that you spend. However, your lender may impose a minimum amount that you need to borrow in order to make it worth it for the company.
When you're approved for the HELOC, you're given a draw period, usually ranging from 5 to 10 years, followed by a repayment period ranging from 10 to 20 years. You can borrow up to your limit as needed during the draw period without having to go back to your lender and ask for permission. And as you pay off what you owe, you free yourself up to borrow more. If your HELOC has a $100,000 limit and you spend $10,000, you would have $90,000 left to spend during the draw period. If you repay the $10,000 during that time, you would then have another $100,000 to spend.
Some HELOCs allow you to pay just the interest during the draw period, while others require you to make payments toward both interest and principal. Paying the principal during the draw period will help you to repay the loan faster, and you'll end up paying less in interest overall. Interest rates on HELOCs generally start higher than home equity loan interest rates, and they're variable, so they can increase over time. This means you won't have a predictable monthly payment that you can plan for. Some HELOCs will allow you to convert the balance to a fixed interest rate at any time during the draw period. You can't do this once you've entered the repayment period, but you could refinance to a fixed-rate loan.
A HELOC could work for you if you know you need money, but you're not exactly sure how much you will need. You can just borrow as necessary without having to apply to the bank every time. But it's not a good choice if you're not good at keeping track of your expenses. You could end up spending more than you anticipated and you may have trouble repaying it.
Alternatives to home equity loans and HELOCs
A home equity loan or a HELOC can be a good choice if you're looking to add value to your current home, but they are rarely a good idea otherwise. If you fall on hard times and can't pay back what you borrow, you'll lose the roof over your head.
Those who don't want to risk that should look into alternatives, like borrowing from friends or family or taking out a personal loan. Depending on the cost and your credit limit, you may also be able to charge some of the expenses to a credit card. This is rarely a good idea, however, unless you know you can repay your balance in full at the end of the month or you're in a 0% introductory APR promotion.
Home equity loans and lines of credit are a viable option for homeowners in need of some cash, but it's important to evaluate all of your options before putting your home on the line, especially if you're still paying off your first mortgage.