Home Equity Loan or HELOC: Which Is Right for You?

By Dan Rafter on 27 January 2016 0 comments

You'd like to renovate your 1970s-era kitchen. Or maybe it's time to build that master bedroom suite you've long desired. But where to get the money?

If you have equity in your home, a home equity loan or home equity line of credit — better known as a HELOC — might be the right choice. With both of these loan products, you'll be using the equity in your home to receive an influx of cash that you can then use on anything you want, such as home improvements, your children's college-tuition fund, paying off high interest rate credit card debt, or even taking a cruise around the world.

But you do have to pay back the money, of course. And you should also understand the differences between a HELOC and a home equity loan. Despite the similar names, these products are different. And one might be the better choice for you. (See also: 21 Real Estate Terms Every Home Buyer Should Understand)

Home Equity Loans

A home equity loan is similar to your primary mortgage loan, only smaller. You can borrow a certain amount as long as it does not exceed the equity in your home. For example, if you owe $150,000 on your mortgage loan and your home is worth $200,000, you have $50,000 of equity in your home.

Most lenders won't lend you that full $50,000. But you might be able to take out a loan for, say, $35,000. You'd then receive those dollars in one lump sum that you'd pay back with regular monthly payments, much like you do with your primary mortgage loan.

Your home equity loan will come with its own interest rate, which is usually fixed. You will also have a set number of years, perhaps 10, to pay it back, and a monthly payment that remains the same until you do pay off your debt.

HELOCs

A HELOC acts more like a credit card with a maximum spending limit tied to your home's equity. If you have $50,000 of equity, your lender might approve you for a HELOC with a maximum borrowing limit of $40,000. You can then borrow as much or as little as you need to cover home repairs or other expenses.

Here's an example: Say you want to spend $20,000 to renovate your home's kitchen. If you have a HELOC with a spending limit of $40,000, you'd be able to borrow that $20,000 and still have $20,000 more to borrow in the future.

You can't borrow off a HELOC forever. Most come with what is known as a "draw period" that lasts from five to 10 years. This is the period during which you can borrow off your HELOC. You'll also make monthly payments depending on how much you've borrowed, but you'll only have to pay the interest on the money you borrowed, not the principal.

After this period ends, your HELOC will enter its repayment period. During this time, you'll pay back whatever you borrowed in monthly installments. Your monthly installments will be larger or smaller depending upon how much you borrowed, just like with a credit card. If you only borrowed $10,000 during the life of your HELOC, your monthly payments will be smaller than if you borrowed $40,000.

What's Right for You?

So, should you go with a home equity line of credit or a HELOC? That largely depends upon your personality.

If you prefer monthly payments that never change along with an interest rate that remains fixed, then a home equity loan is your better choice. These loans are also a smart move if you have a specific project that you want to fund. If you know you need $15,000 to cover the costs of a second-floor addition to your home, you can borrow exactly that amount with a home equity loan and then know exactly how much that loan will cost you each month.

A HELOC comes with more uncertainty. The interest rates attached to HELOCs are usually adjustable, meaning that they can rise or fall. This also means that your payments during the repayment period might increase.

But HELOCs are a good choice if you want some flexibility with your money. Say you're taking on a long-term home renovation. If you take out a HELOC, you can withdraw money whenever you need to pay your contractors. This gives you access to a pool of funds without having to pay interest on that money until you actually borrow it.

"People should simply consider whether they are comfortable with an adjustable rate, because a line of credit will be adjustable," said Matt Hackett, operations manager with New York City-based direct mortgage lender Equity Now. "If they are, then they should consider whether they are likely to draw the entire portion up front, or whether they want to have access to the funds, but don't need to draw it all at one time. If they do not need it all at once, the line may be a better option as they will only pay interest on the funds they draw."

Lenders also tend to charge lower fees to start a HELOC than to originate a home equity loan, and home equity loans often come with interest rates that are higher than the starting rates for HELOCs. With a home equity loan, you have to pay interest on all the money you borrow all at once, whether you use that money or not. With HELOCs, you only pay interest on the money that you end up borrowing, even if you have access to more funds.

Just be careful: Having that big line of credit that comes with a HELOC is tempting. You might spend it recklessly, borrowing, say, $5,000 for a last-minute family vacation instead of saving up the funds in advance to take such a trip. Home equity loans are often better choices for consumers who don't trust themselves to make the smartest money decisions.

Have you borrowed on the equity in your home? Which form did your loan take?

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