How does a home equity loan work?

Homes & real estate
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How does a home equity loan work?

Homes & real estate

With real estate values on a seemingly never-ending rise, a home equity loan or home equity line of credit seem like a no-brainer.

Use the money to pay off high-interest debt, and you could save hundreds or even thousands of dollars on interest charges. Make some much-needed repairs or improvements to your house, and you’re essentially paying yourself to increase the value of your property.

Smart, right?

Even though it might be a smart choice, it’s not entirely without downsides. For one, you’ll need to be diligent about repaying the loan. Plus, the temptation to splurge on big-ticket luxury items may be hard to ignore.

Below we’ll take a look at the difference between home equity loans and home equity lines of credit, and examine some of the reasons why one might be a better fit for you.

Home Equity Loans

At its heart, a home equity loan is the same as a second mortgage. You borrow a set amount of money at a fixed interest rate and make monthly payments over the loan period (usually 10-15 years).

Advantages of a home equity loan:

  • A fixed interest rate which protects you from later rate hikes.
  • It may be easier to qualify for if you have bad credit since it’s a secured loan against the value of your home.
  • A monthly payment schedule keeps you on track to repay the loan.
  • Home equity loan interest rates are lower than credit cards (though likely higher than your mortgage rate).
  • Using a home equity loan to pay off high-interest credit cards can save you money on interest charges.
  • Home equity loan interest may be tax-deductible. Consult a tax professional to determine whether you qualify and, if so, how much you may deduct.

Disadvantages of a home equity loan:

  • If you’re borrowing to pay for something over the course of months or years—for instance, a child’s college tuition—you’ll have to make sure you don’t succumb to the temptation to spend the money on something bright and shiny.
  • Purchasing a depreciating asset such as a car, RV, or vacation with a home equity loan will negatively impact your net worth.
  • The terms of some home equity loans restrict you from renting out your property so you’ll have to stay put until it’s repaid.
  • If you fail to keep up with payments, you may lose your home.

Home Equity Lines of Credit (HELOC)

HELOCs are functionally the same as a credit card that is secured by the value of your home. And as with credit cards, you’ll have a maximum amount you can borrow that will be determined by the value of your home minus whatever remains on the mortgage. Your rate will be based on your credit history, current debt, and income.

The lender will either give you a set of blank checks or a credit card to access the money.

Advantages of a HELOC:

  • You can borrow what you need when you need it. You’re not stuck with a set amount.
  • HELOCs can function as a safety net. If a crisis hits, a HELOC can help you get through it.
  • Interest rates may be lower than credit cards or other consumer-level credit options.
  • HELOC interest may be tax-deductible. Consult a tax professional to determine whether you qualify and, if so, how much is deductible.

Disadvantages of a HELOC:

  • HELOC interest rates are variable and tied to the prime rate, so failure to keep up with payments can be costly.
  • Some HELOCs require you to withdraw a minimum amount each time and to start withdrawing money within a set time period.
  • HELOCs have a variety of attached fees such as a current property appraisal, application fee, closing costs, and points. There may also be a transaction fee each time you pull money out.
  • HELOCs have a fixed end date. When it arrives, the balance of the loan is due in full. Failure to keep up with payments may result in a painfully large final payment.
  • HELOCs are fairly easy to get which means borrowers with less than stellar impulse control run the risk of losing their home if they end up with larger debts than they can pay off
  • The terms of some HELOCs restrict you from renting out your home so you’ll have to stay put until it’s repaid.

As you can see, home equity loans and lines of credit offer property owners two excellent options for making a variety of improvements to your home and in your life. Care should be taken, however, when considering which option best fits your needs and mindset.