Homeowners who look to their property as a source of cash often consider a home equity line of credit (HELOC) or a more traditional home equity loan. There are advantages and disadvantages to each. In addition, the way a HELOC works is quite different from how a standard home equity loan. Anyone who is thinking about pulling money out of a home’s equity should understand the basic differences, how each method works, and what circumstances are ideal for each type of borrowing.
The “LOC” in HELOC is instructive, and reveals a lot about this type of borrowing. The home equity line of credit is just that, a “line of credit” rather than a lump-sum loan. When you are approved for a HELOC, you’ll be given an approval letter, not a check. Here are some other important facts about HELOCs:
- There’s a “draw period,” during which you can pull out any amount of your equity up to the approved limit. During the draw period, you pay principal and interest, just as you would on a typical home loan. Some lenders allow borrowers to make “interest only” payments during the draw period, but that feature is usually offered to people with very good credit, very high equity, or both.
- After the draw period comes the payback period. During this time, you’ll not be able to take any more money out of the equity. It’s simply a repayment period when you pay principal and interest for a set amount of time.
- The interest rate is usually varied, so you won’t always know what your monthly payments will be. This can be a plus or a minus, depending how the market rate of interest behaves. Some can be converted to fixed-rate loans after a few years, but that depends on the particular home equity lenders.
- For long projects like remodeling, this can be the best way to go. You have the advantage of pulling out as much or as little cash as needed, month to month. There’s no need to lock yourself in to a predetermined amount of debt, which can be the perfect way to finance home remodeling projects that take many months to complete.
Home Equity Loans
Those who would rather borrow against their home equity in a more traditional, straightforward way opt for home equity loans. Rates tend to be fixed, and loan repayment periods are determined at the time of the loan. You’ll pay interest and principal on the note until its fully repaid.
- Home equity loan rates are usually higher than HELOC interest rates and have repayment periods that range from 5 to 30 years.
- For one-time expenses and emergencies, this route can be a wise choice. They’re designed for borrowers who know the exact amount of money they need.
- Most experts advise against using these loans for anything other than an emergency or the purchase of an income-producing property. Events like vacations, luxury remodeling and non-essential expenses are, generally speaking, not a good reason to borrow against your home.
Pros and Cons
Carefully assess your reason for wanting to borrow against your home. Then, decide whether a HELOC or a traditional home equity loan is the right way to go.