We’ve all faced situations in life when having access to money or a line of credit would be extremely helpful. Whether you're handling an unexpected "cash crunch" (e.g., car repairs, medical bills, etc.) or you're looking to put the money towards a major expense (e.g., remodeling your home, financing your child's college education, etc.), you've probably heard you can tap into the equity in your home to take care of situations like these via a home equity loan or home equity line of credit (HELOC).
While both of these financial options are extremely popular, which one makes sense for your situation? Below are some key points to help you determine if a home equity loan or line of credit will be right for you.
What is a Home Equity Loan?
A home equity loan is known as a "secured" loan, which means your home is used as collateral against the amount of money you borrow. Since your home secures the loan, you can generally get a more favorable interest rate on the loan than if there was no collateral involved. This means you will pay less money in interest charges over the life of the loan.
There are many reasons this type of loan would make sense for different situations, but there are some risks to consider as well. If something goes wrong and you default on your loan, the lender has the right to take your home in order to satisfy the debt. While most banks use this option as a last resort, it is still a risk you’ll need to consider before signing on the dotted line.
The important thing to remember is to only borrow the amount of money you reasonably believe you’ll have the ability to pay back (based on the foreseeable future) according to the repayment schedule.
Related post: 3 Tips for Using Home Equity the Right Way
What is a Home Equity Line of Credit?
A home equity line of credit (HELOC) is different from a home equity loan in that it's not a lump-sum withdrawal of cash – instead, you can access the funds any time you need it.
HELOCs allow you to tap into additional funds equal to about 80 percent of your home's value minus the balance outstanding on your mortgage, and then there are other final adjustments made (based on your credit score and so forth) that ultimately determine the amount you can access.
Unlike home equity loans, HELOCs typically carry variable interest rates, which can leave you vulnerable to paying more than you bargained, should rates begin to rise. The main benefit that a HELOC affords is flexibility, because you can access the funds as you need them instead of receiving one big chunk of cash at the onset. This might be a more suitable option for you based on your particular situation.
Is a Home Equity Loan or Line of Credit Right for Me?
The honest answer is "it depends." Every person's situation is different, and the reasons for needing cash can vary greatly from one person to the next.
One piece of advice almost always universally accepted is that you shouldn't use either borrowing option if it's only for discretionary purposes, or things you could pretty much do without. The risks will outweigh the benefits in these scenarios, and should an actual emergency arise later, you might not have the funds available since you already tapped into your home's equity for non-essential purposes.
It's much better to save these types of borrowing options for genuine needs, or things that could boost the equity in your home even further, such as financing a major remodeling project. By using your borrowed funds to further increase your home's value, you could create an even larger equity cushion to benefit your bottom line in the long run.
No matter which option you choose, be sure to carefully weigh your options ensuring it's worth the risk, and then make those payments on time. Take the time to speak with a loan professional who can guide you and select the best option for your financial needs.
- Everything You Need to Know About Home Equity Lines of Credit
- 3 Reasons to Refinance Your Home
- How to Recover from a Mid-Life Financial Crisis
- Fixed vs. Adjustable Rate Mortgages