I was asked this question recently and thought that this might be a good place to talk a little about these two types of products.
What is the difference between a “Home Equity Loan” and a “Home Equity Line of Credit” and when should I use them?
First, let’s start with the basics. When you buy a house you get a mortgage, usually for the amount of the purchase price, less any down payment you make. Your monthly mortgage payments are made up of principal, interest, taxes, and insurance, commonly referred to in the industry as “PITI”. Every payment pays down a portion of your loan principal along with the interest charged by the lender to give you the mortgage, as well as taxes and mortgage insurance.
With each payment, the portion that goes toward the loan principal is how much more of your home you own. You might have heard it said that that’s the “equity” you have in your home. So on a home of $500,000, if you pay your very first mortgage payment and $100 of that payment goes toward the principal, you now have $100 of equity in your home. With every payment, you slowly pay down more and more of your loan principal so that eventually you end up paying for your entire home… 100% equity in your home.
Over the course of your mortgage, while you have some equity in your home but you don’t own your home free and clear, you can borrow that money, usually up to (or close to) the amount of equity you have in your home. So, let’s say that after several years of mortgage payments, you have built up $100,000 equity in your $500,000 home. You can borrow against some of that equity. Here’s where HEL and HELOC come in.
Home Equity Loans (HEL) are slightly different than Home Equity Lines of Credit (HELOC). A loan is when you borrow money once and have to pay it back. Once you’ve paid it back, the loan is done. Usually there is a time limit that you have to pay it back. A line of credit, though, is called “revolving credit” or, you can think of it as an ongoing loan. You can borrow it, pay it back, borrow against it again, and pay it back. As long as you keep paying it back, you can keep borrowing against it. If, for whatever reason, you choose not to pay these back, they are added back in to your mortgage payments.
So, should you get one? If so, which one should you use? At Realty Counselors Inc, we feel that one of the wisest uses of either a HEL or a HELOC is to grow the value of your home. So, for example, you might want to borrow against the $100,000 equity in your $500,000 home to make improvements on your house and property, increasing the value to $600,000 or more. That’s a great use of these loans. Another smart use of the money might be to compare interest rates between these home equity loan products and your credit card. If you have high credit card bills, you may want to borrow against your home’s equity (which is likely a lower interest rate) and pay off your credit cards.
You may want to consider taking out one of each on your home: an HEL for home improvements and an HELOC that you only use in case of emergencies… because it’s always nice to have that money available if you need it.
Whatever you decide, be sure to think through carefully:
• Will you need the money once (in which case you want an HEL) or will you need it available to you on an ongoing basis (in which you will want a HELOC)?
• Will you be able to pay back the loan or line-of-credit AND your mortgage at the same time?
• Are you using an HEL or a HELOC wisely, to pay off higher interest charges, or are you tempted to unwisely use this “new found cash” to buy frivolous items?
It’s nice to know that you have options if you have worked hard to build up equity in your home.
Armen Gukasyan is Founder and President of Realty Counselors Inc, a Los Angeles-based real estate and mortgage consulting and brokerage firm. He is also the author of The 24 Laws of Marketing Every Real Estate Practitioner Must Know
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