Things break. Emergencies happen. And if you are like many Americans, you may not have the extra cash on hand to pay for these expenses. Homeowners generally have two options for getting the money they need — a home equity line of credit or a home equity loan. To qualify for these financial products, also known as “second mortgages,” homeowners must have equity in the home — in other words, your home must be worth more than what you owe on it. Generally, banks also look at credit scores and the bill-paying habits of the borrowers before approving them for either product. The home equity plan that is best for you will ultimately be determined by your financial needs.

Home equity lines of credit: The basics

Using a home equity line of credit (or HELOC) is similar to using a credit card. Once an appraiser determines how much equity is in your home, the bank will set the amount of credit you can receive. The borrower will have a set amount of time to use the credit.

The borrower has two options:

  • Use all the credit at once. For example, a borrower is approved for a $20,000 line of credit and uses all of it for a major home renovation.
  • Draw out the money as it is needed. A borrower may use $5,000 to pay off medical bills, and then use another $15,000 to pay for a child’s college education.

Repayment and interest rates on home equity lines of credit

A variable interest rate is used for a line of credit. That means the rate you are charged will change as interest rates do. If interest rates are declining, you will pay less. But if interest rates increase, so do the payments on your credit line.

Borrowers can also decide how they want to repay the loan. Monthly payments can be made to help pay off the principal and interest. Or borrowers can just pay the interest through the draw period. Once the draw period ends, the borrower will be responsible for paying off the entire loan.

Home equity loans

Home equity loans work more like traditional loans and are more straightforward. You are approved for a certain amount. You receive the money all-at-once and pay it back monthly. Your interest rate is fixed and your payments never change. In this way, it’s like buying a car. You get approved, an interest rate is set and you make your monthly payments.

How do I know which is right for me?

Both loans have their advantages and potential disadvantages. Here’s a quick look at both:

Home equity credit line advantages:

  • You will have access to cash when you need it.
  • Your payments could be lower when you are just paying interest.
  • You only pay interest on the money you take from your line of credit.

Home equity credit line disadvantages:

  • You will pay more if the interest rate increases.
  • You have to manage your credit line well and not overspend. You don’t want to use all of the equity in your home.

Home equity loan advantages:

  • You get the entire amount immediately.
  • Your payment stays the same for the life of the loan.
  • You have access to cash for emergencies.

Home equity loan disadvantages:

  • You will have fewer financial options in the future if you borrow all the equity in your home.
  • You may not use all your equity.

Both loans may qualify for a tax deduction when the money is used for home improvement. You need to talk to your tax professional if a tax break is a factor in your decision.

These types of loans are risky. Home values can decrease for several reasons and leave you paying more than your home is worth even if you keep your home in great shape. For instance, a change in zoning laws or a decline in the desirability of the neighborhood can drive down property values.

Consider your current financial needs and carefully assess exactly how much you will be able to repay before taking out a home equity loan or line of credit. After weighing the advantages and disadvantages of each, sit down with a loan officer and determine which loan is best for you.

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