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By Jamie Smith
A home equity line of credit (HELOC) and a home equity loan are two ways to leverage the equity in your home to finance or pay off a big purchase. Equity is the difference between what you owe on your house and the house's fair market value. Both use your home as collateral on the loan or line of credit. If you don't pay it back, you could go through foreclosure on your home, so this is a decision you should not make lightly.
However, having your home as collateral could mean getting a lower interest rate than you would from unsecured loans or credit cards. You may ask yourself, "Should I get a home equity loan or a HELOC?" Examine some of the main differences between the two and some cases where one is better than the other to make the right choice for your situation.
A HELOC differs from a home equity loan in that it's a revolving line of credit that is similar to a credit card. You can borrow as much or as little as you need against the entire credit line and with an interest-only HELOC. You can make interest-only payments on what you borrow during the draw period. It's similar to a home equity loan in that you can typically only borrow against 80% to 85% of your equity. However, the interest rate isn't fixed. Rather, it is based on the current federal interest rate plus a specific number of points.
Your interest rate could go up or down depending on the financial market. A HELOC has two phases: The draw phase and the repayment phase. During the draw phase, you can withdraw money against the line of credit, and you can use as much or as little as needed. With an interest-only HELOC, the only payment required is the monthly interest due. You can pay more if you'd like, but you're only responsible for the interest. The draw phase is typically five years or less. You can refinance and perhaps extend your draw phase; otherwise, you'll enter the repayment phase.
The repayment phase is usually in the 15- to 25-year range and consists of regular monthly payments covering interest and principal. You can think of this arrangement as a home equity loan or a mortgage.
To summarize the benefits, you only borrow what you need and can do so without reapplying. Since the amount you can borrow is based on equity, getting a HELOC on a newly purchased home may not make sense. Like a home equity loan, a HELOC may be tax-deductible when applied to home renovations. Please consult your tax advisor regarding interest deductibility as tax rules may have changed. However, you want to be careful about having access to a potentially significant credit line to avoid being tempted to overspend.
A home equity loan is a large lump sum payment based on a percentage of the equity in your home. The general rule is that lenders allow about 80% to 85% of the equity in your home as the maximum amount you can borrow. For example, if you have $50,000 in equity, you could get between $40,000 and $42,500 in a home equity loan. Once you have applied and supplied all the necessary documentation and are approved, you will get the amount in one lump sum. The loan term can vary between five and 20 years, occasionally stretching out to 30 years as a standard mortgage would.
The loan's interest rate is fixed throughout the life of the loan, as is the monthly payment, making it easier to budget every month. Other benefits allow you to pay it off quickly to get rid of debt faster or over up to 30 years to make it more affordable while providing much lower interest rates than credit cards or personal loans. Also, if you use your home equity loan for qualified home renovations, you may be able to deduct the interest paid from your taxes. Please consult your tax advisor regarding interest deductibility.
Defaulting on your home equity loan could result in foreclosure. A home equity loan adds another house payment to the monthly mortgage you're already paying, adding additional financial obligations. The interest rate is fixed, but it can run higher than a HELOC rate.
Another point to consider is that if you borrow against too much of your equity, you could run into issues if your property values decline. Finally, as with your first mortgage, a home equity loan involves closing costs and other fees.
"Should I get a home equity loan or a HELOC?" Before you answer this question and decide, you must consider several factors:
The application process for a home equity loan and home equity line of credit is very similar. Before starting the application, you can streamline the process through these steps:
An Alliant HELOC could help you get the funds you need when you need it. Pay for a home renovation, vacation home and more.
Want to learn more about HELOCs? Read these additional articles:
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