Selling your home for a profit can mean a substantial windfall. But in the meantime, while you’re living there, that gain is locked up, out of reach — unless you access the equity with a home equity loan or a home equity line of credit, known as a HELOC.
These two types of “second mortgages” are drawn on the value of your home above and beyond what you owe on your primary mortgage. Weighing the pros and cons of each will help you decide which one is right for you.
Many financial planners say the only acceptable reason to tap your home equity is for things that will increase its value. Consider that as you assess the characteristics of home equity loans versus lines of credit.
How to calculate your home equity
To find out how much equity you’ve built up in your home, subtract the amount of money you owe on your mortgage from your property’s value. Depending on your financial track record, lenders may let you borrow up to 85% of your home equity. Keep in mind, though, that you’re using your home for collateral, so the lender can foreclose on your property if you default on your payments.
The amount you owe on outstanding home loans divided by the market value of your home is considered the combined loan-to-value ratio. If that ratio is high, lenders will hesitate to let you borrow more against the home’s value.
An example: Your home is worth $300,000, and you owe $150,000. If you divide 150,000 by 300,000 you get 0.50, which means you have a 50% loan-to-value ratio. A lender that allows a combined loan-to-value ratio of 80% would grant you a 30% home equity loan or line of credit, for $90,000.
» MORE: How much house can I afford?
HELOCs and home equity loans compared
|An adjustable interest rate|
|A fixed interest rate|
(Some lenders allow conversion to fixed rate)
|Interest paid may be tax deductible|
|Draw money as you need it|
|Pay interest only on the amount you draw|
|Interest-only payments option|
About home equity loans
Home equity loans typically have a fixed interest rate, meaning the payment is the same each month; that makes them easier to factor into your budget. But remember: That home equity loan payment will be in addition to your usual mortgage payment.
Since it’s a lump sum one-time equity draw, a home equity loan is a good source of money for major projects and one-time expenses.
Home equity loans pros and cons
- Pro: A fixed interest rate.
- Pro: Interest paid is usually tax deductible.
- Con: Tapping all the equity in your home in one fell swoop can work against you if property values in your area decline.
» MORE: Calculate your refinance savings
About home equity lines of credit
HELOCs and home equity loans are similar in that you’re borrowing against your home equity. But a loan typically gives you a sum of money all at once, while a HELOC is similar to a credit card: You have a certain amount of money available to borrow and pay back, but you can take what you need as you need it. You’ll pay interest only on the amount you draw.
HELOCs often begin with a lower interest rate than home equity loans but the rate is adjustable, or variable, which means it rises or falls according to the movements of a benchmark. That means your monthly payment can rise or fall, too.
Many lenders will let you carve out a portion of what you owe on your HELOC and convert it to a fixed rate. You’ll still have the balance of your line of credit to draw from at a variable rate.
Home equity lines of credit pros and cons
- Pro: Pay interest compounded only on the amount you draw, not the total equity available in your credit line.
- Pro: May offer the flexibility of interest-only payments during the draw period.
- Pro: Interest paid is usually tax deductible.
- Con: Rising interest rates can increase your payment.
- Con: Without discipline, you might overspend, tapping out the equity in your home and finding yourself saddled with large principal and interest payments during the repayment period.
Terms and characteristics of home equity loans and lines of credit vary from one lender to another. Be sure you understand the repayment terms of your loan before you commit to a lender, and don’t be afraid to shop around before you sign on the dotted line.
Which is better when?
Before deciding whether to apply for a HELOC or a home equity loan, consider how much money you really need and how you plan to use it. Factor in interest rates, fees, monthly payments and tax advantages as you weigh your options.
Using the equity in your home before selling can be a powerful financial benefit. But remember, you’re using your home as collateral. One risk to avoid, whether you choose a home equity line of credit or a loan: Resist funding short-term needs with what may eventually amount to a long-term loan.
Updated Jan. 24, 2017.
The article Home Equity Loan Versus Line of Credit: Pros and Cons originally appeared on NerdWallet.
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