Home Equity Loan or HELOC? Here’s the Difference

Both loan products have their place -- but you need to know how they work

Home Equity Loan or HELOC? Here’s the Difference

Need money to renovate your kitchen? Maybe you’d like to pay off those high-interest-rate credit cards or help cover the cost of your children’s college education.

The good news? If you own a home and you have equity in it, you can apply for a home equity loan or line of credit to pay for these big expenses.

But how do these loan products work? And which one is the better choice for you, a home equity loan or a home equity line of credit?

Here’s a look at the differences between these products.

What is equity?

To apply for either a home equity loan or a home equity line of credit – more commonly referred to as a HELOC – you’ll need to own a home and have equity in it.

Equity is the difference between what your home is worth and how much you owe on your mortgage. If your home is worth $250,000 and you owe $150,000 on your mortgage, you have $100,000 of equity. A lender, then, might approve you for a home equity loan or HELOC of $80,000, borrowed against the equity of your home.

How home equity loans work

With a home equity loan, you borrow against your equity and receive a payment in one lump sum. You then repay this loan each month, with interest, just as you do with your primary mortgage loan.

Say you have $80,000 of equity in your home. Your lender might approve you for a home equity loan of $60,000. You’ll then receive a check for that amount. You’ll repay the $60,000 with monthly payments, usually at a fixed interest rate.

You can use the money you borrow on anything. If you want to add a master bedroom suite to your home, you can use a home equity loan to do so. If you want to pay off your credit card debt – swapping the lower-interest-rate home equity loan debt in its place – you can do that, too. You can use your home equity loan to pay for your children’s college tuition, if you’d like.

A home equity loan can even bring you a deduction come income tax time. If you use your home equity loan for a home-improvement project that increases the value of your home, you can write off the interest you pay on it throughout the year. Be careful, though: You can only write off the interest in this specific circumstance. If you use your home equity loan for another purpose, such as paying down your credit card debt, you can’t write off your interest payments.

How does a HELOC work?

A HELOC works more like a credit card than a standard loan. The difference? Your credit limit is based on the equity in your home.

Say you have $100,000 worth of equity. A lender might approve you for a HELOC with a maximum borrowing limit of $80,000. You can then borrow against this limit whenever you’d like. Maybe you want to take on a kitchen remodeling project that will cost you $30,000. Instead of borrowing the entire $80,000 available to you, you’ll borrow just $30,000.

With a HELOC, you only pay back what you borrow, again with interest. If you only borrow $30,000, then, you only pay back that amount in monthly installments.

Again, you can use the money you borrow for anything you’d like.

Which option is better?

Should you choose a HELOC or home equity loan? That depends largely on what you want to use the money for.

A home equity loan is usually a good choice if you want to take on a specific project. Maybe you want to remodel your home’s kitchen. A home equity loan is a good choice for the funds you need thanks to their low interest rates and fixed monthly payments. It’s easier to budget for your monthly payments if they stay the same.

A HELOC provides more flexibility and is good if you want access to a line of credit that you can tap whenever projects or expenses crop up. Borrowers often choose HELOCs when they don’t know how much money they’ll need.

Remember, though, that HELOCs come with a specific draw period: You can only borrow money during this period, which typically lasts 10 years. After the draw period ends, you’ll enter the repayment period, during which you’ll have to pay back the principal of what you’ve borrowed, with interest.

personal finance

Art loves writing about anything. He really isn't the biggest fan of most people.

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