What option is best?
If you have equity in your home, borrowing against that equity can be a great way to obtain funds for a home renovation or another large purchase. There are two common ways to borrow against your home equity. One option is a home equity loan, and the other is a home equity line of credit, also known as a HELOC. Which option is right for you? Well, that depends on your financial situation and preferences. Learn a little more about both options—their pros and their cons—and then decide for yourself.
Home Equity Loans
A home equity loan is a lump sum of money that you are given all at once. When you take out a home equity loan, you are essentially taking out a second mortgage. Generally, lenders will allow you to borrow up to 85% of the equity that you hold in the home. So if you have $100,000 in equity, for example, the bank will be willing to lend you up to $85,000. This does not mean that you have to borrow the full $85,000; you can certainly borrow just $10,000 or $20,000 if that's all you need.
Home equity loans generally have a fixed interest rate, which is one benefit that they have over HELOCs. You'll know what your monthly payment is, and you'll make that same payment for the life of your loan.
One small downside of a home equity loan is that if property values in your area decrease, you may end up owing more on your home than it is worth. This is mostly a concern if you plan on selling your home in the next few years. There is a chance you won't be able to sell the home for enough money to pay off your first mortgage and the home equity loan.
Home Equity Lines of Credit (HELOC)
A HELOC is more like a credit card account than a traditional loan. You won't receive a lump sum of money up-front. Rather, you will be issued a line of credit, and you'll be able to spend money against your equity over time, up to a certain limit. For example, you can take out $3,000 for new carpet one month and another $4,000 for new cabinets the next.
With a HELOC, you will have a payment due each month, but that payment will vary depending on how much you have borrowed. The interest rate of a HELOC is also adjustable. Many HELOCs are issued with low introductory interest rates, but the interest rate then rises over time. Some banks do give borrowers the option of converting their HELOCs into fixed-rate loans after a certain period, which will make payments more predictable.
HELOCs do offer more flexibility than home equity loans. Sometimes, you may not have to pay interest during the withdrawal period, which may make a HELOC the more affordable choice if you only need to borrow money for a short period. Still, you will need to exercise self-control to avoid borrowing more than is necessary or more than you can afford to pay back. This is the same type of responsibility you should exercise when using a credit card.
Borrowing against your home's equity can be a good way to obtain funding for an important purchase. If you want a lump sum with a predictable payment, a home equity loan is the way to go—and if flexibility is your top priority, a HELOC may be preferable. Both options work well for customers who borrow wisely, responsibly, and within their budget.