A home equity loan helps homeowners access a lump sum of money more easily than other types of loans. Rather than applying for a personal loan, a borrower uses his or her own home as security. If the loan defaults, it is the borrower who is negatively impacted.
A home equity line of credit (HELOC) is like a loan in that it provides cash while using the owner’s home as security. Unlike a home equity loan, a HELOC does not provide one lump sum of cash but allows the borrower to make multiple withdrawals.
There is a limit to the total amount of money available through a HELOC, but this gives borrowers the option to take out smaller amounts more frequently. If you are still wondering “how does a home equity line of credit work and how does it differ from an equity loan?”, then keep reading to find out the key differences.
What is a home equity loan?
A home equity loan is like any other loan available from banks or lenders. With it, borrowers can pay off or consolidate large amounts of debt. However, instead of going through a loan approval process for a personal or consolidation loan, borrowers use their own homes as security.
The home equity loan requirements are generally less strict than other loans. As long as a borrower’s home is worth more than they owe on it, they are qualified to take out this type of loan. The term “equity” refers to the portion of their home that they own. In other words, it is the total amount of money that the borrower has paid into their home up to date.
Benefits of a home equity loan include interest rates that are lower than personal loans or credit cards. Most are quoted as annual percentage rates (APRs), which can help keep borrowing costs low.
Additionally, borrowers are not required to spend the lump sum they receive on home-related improvements. In fact, many borrowers choose to take out an equity loan to help pay for large expenses, such as the cost of higher education or starting a business.
The Risks of a Home Equity Loan
A home equity loan comes with its share of disadvantages. One major risk that borrowers face is not being able to afford their scheduled monthly payments. Failing to pay back the loan allows the bank to foreclose on their home. Therefore, it is pertinent that borrowers understand the risks associated with a home equity loan.
Borrowers must evaluate whether or not they are financially capable of making these payments. Because borrowers often prioritize this payment, they typically miss other important payments as well. Skipping credit card bills, auto loan payments and other monthly responsibilities can lead to other issues.
Taking out a home equity loan can also cost more than other types of loans when adding up the total. It may come with a lower interest rate, but it can costs thousands in closing costs.
What is a home equity line of credit (HELOC)?
A home equity line of credit, otherwise known as HELOC, is an alternative to an equity loan. It provides homeowners with more flexibility than a loan because it acts more like a credit card.
If you are wondering “how does a home equity line of credit work?” you are not alone. Many borrowers confuse a HELOC with a standard equity loan. However, there are many key differences that make a HELOC more beneficial.
Unlike a home equity loan, borrowers who take out a HELOC are eligible to make multiple withdrawals of varying amounts. The HELOC has a maximum amount, but borrowers can control how much they use of that amount and how often they withdraw it.
A home equity line of credit may be used for recurring expenses rather than one-time expenses. Borrowers can access their money as needed to pay for things like tuition, medical bills and small home improvement costs.
There is more flexibility when it comes to interest payments as well. Borrowers have complete control of their loan balance and interest costs because they only pay interest on the amount used from the total pool of available money.
A home equity line of credit also has variable interest rates, which can be a good and a bad thing. When rates go down, borrowers pay less interest over time. When they rise, however, borrowers are forced to pay the difference.
How to Choose Between a Home Equity Loan and HELOC
Deciding between a home equity loan and HELOC is a matter of personal financial goals. Both options offer borrowers a way to obtain large amounts of money by using their home as security. But there are certain drawbacks to each that may not make sense for some individuals.
A home equity loan may be the perfect option for borrowers who have specific home renovation needs in mind that come with exact costs. A lump sum of money can help them purchase materials and pay contractors with a set interest rate. They never have to worry about rising interest costs over time.
A home equity line of credit, on the other hand, may be the best option for borrowers who do not have one giant expense in mind. Instead, they may have a few recurring expenses. This option is also ideal for borrowers who want to control their loan balance and interest payments.
If you’re still wondering “how does home equity work?” the bottom line is this: both equity options grant homeowners access to large amounts of money more easily than a personal loan or credit card. Your choice depends upon your situation and your intentions for using the money.