Between replacing the family car every few years, remodeling the kitchen, and paying Junior's tuition, even consumers who don't consider themselves big spenders can end up with some hefty bills on a regular basis. Of course, you could use a credit card or take out a personal loan to pay them, but a home equity loan, with its lower interest rates and tax-deductibility, is often a better option.
Home Equity Loan vs. Line of Credit
Whether to choose a home equity loan (also known as a second mortgage) or a home equity line of credit (HELOC) will depend on how you plan to use the money.
A home equity loan provides you with a lump sum at a fixed interest rate, which you repay in equal installments, typically over 10 to 15 years. If you end up needing more money than you borrowed, you would have to take out a brand new loan.
Home equity loans are excellent for single large expenses, like a home remodel or your daughter's wedding. With fixed terms on a specified amount, you know exactly when the debt will be paid off and you won't be affected by rising interest rates.
A home equity line of credit functions like a big credit card. You can borrow as much or as little as you want up to your pre-determined limit. Monthly payments will be calculated based on your outstanding balance and a fluctuating interest rate (just like a credit card). As you pay off the balance, those loan funds become available for you to borrow again. Like the home equity loan, a line of credit has a term (usually between 10 to 20 years), at which point the balance has to be paid off.
A HELOC is ideal if you want to tap into your equity to pay for such things as your daughter's annual tuition or to make small home improvements from time to time because you'll pay interest only on the amount of money you are using at any particular point.
Risk and Rewards of Borrowing Against Your Home
Home equity loans and lines of credit have a couple of major advantages over other borrowing options. First, they tend to charge lower interest rates than you would find on many other types of credit. It's not unusual for rates on home equity debt to be half what is charged on a personal loan or a credit card.
Second (and the major attraction), home equity loans and lines are, in most cases, tax-deductible up to $100,000. This can have a big impact on your bottom line, and is the main reason why so many homeowners use a home equity line of credit instead of non-deductible loans and credit cards to pay for things like cars, trips and consumer goods.
As great a financial tool as home equity loans and lines can be, they also pose some risks. Because the loans are secured by your home, you run the risk of losing your greatest asset if you can't make the payments. HELOCs can also get you into the "minimum payment" trap, where you make only the minimum payments on your outstanding debt and then find you owe a lump sum "balloon" payment at the end of your loan term.
Getting the Loan
You don't need to get your home equity loan or line of credit from the same lender that gave you your first mortgage. You can find home equity loan products in many places, including credit unions, banks, mortgage companies and online lenders.
The processing costs of both types of home equity loan are typically pretty modest, but you should be aware of them nonetheless. In some cases, an appraisal will be needed. That can cost $250 to $500. There may be some small fees associated with recording the loan documents. For most HELOCs, lenders will also charge an annual fee of between $30 and $100.
As with any loan, the interest rate you will be charged on a home equity loan or line is determined by many variables, including the amount you borrow, your credit rating, the value of your property and the movement of the financial markets. To get the lowest interest rates, you typically need to have at least 20 percent equity in your home.
Finally, if you want to take advantage of the equity you've built while reducing the risk of using your home as collateral, never borrow more than the equity in your home at the time of the loan and always maintain a liquid cash reserve big enough to see you through a temporary financial emergency.
Curious About How Much Your Home is Worth?
Before you consider home equity loan options, you will want to know how much your home is worth so that you can understand how much equity you may have available to you. Click here to download a free article that can help you find out how much your home is worth.