If your mortgage isn’t one of the many that is now “underwater,” you’ve got a good thing going. Maybe you’ve lived in your home for a while, maybe you live in an area of the country that sidestepped most of the recent boom and bust, or maybe you’re just a savvy real estate investor. Either way, you should be breathing a sigh of relief that you don’t owe more on your mortgage than your house is actually worth.
By having more value in your home than you owe, you have what the real estate world calls “equity”. And equity means that you have options when it comes to borrowing for major expenses like college tuition or debt consolidation. Note that I didn’t mention luxury vacations or a boat – the days of using your home as an ATM are over. However, for more legitimate uses, there are two ways to get at your equity and use it to your financial advantage: (i) a home equity line of credit (HELOC), or (ii) a home equity loan.
Why use home equity?
Most bank loans are unsecured, including student loans, credit cards, and most personal loans. Because there is no collateral to back these loans, the interest rates are higher. Mortgages, home equity loans and HELOCs, however, are backed by the value of your home. If you default on these loans, the bank can claim your home, so they’re willing to charge you a lower interest rate. Plus the interest payments on loans that are tied to the value of your home are often tax deductible. If you’re carrying enough debt, one of these loans is a lot better than balance transfer credit cards or other consolidation methods.
When choosing between an equity loan option, the similarity ends there. Both loan types are based on the current equity in your home, but they differ in how the money is distributed, how the interest is calculated, and how you repay them.
| Loan Type | Loan Term | Interest Rate | Payment Terms | |
| HELOC | Revolving line of credit like a credit card | Varies | Variable based on prime rate | Flexible; you can repay as little as the interest due every month |
| Home Equity Loan | Lump-sum amount | Varies | Can be fixed or variable | Fixed monthly payment |
Which to Choose?
A home equity loan provides a lump sum cash payment and is a good choice when you know how much money you need up front, for example when you’re using the money for debt consolidation. Like any other installment loan such as an auto loan, you make fixed monthly payments for a pre-defined time period, until the loan is completely paid off.
A HELOC doesn’t require you to decide on an amount upfront, but instead allows you to borrow funds as you need them, up to a pre-determined amount (which is your total “line of credit”). A line of credit is useful for funding ongoing needs like college tuition, or even home improvements. It can even serve as a substitute for a costly medical credit card, for major health care expenses. As you pay back the principle that you’ve borrowed, you can continue to redraw against the credit line.
Lenders have traditionally allowed homeowners to borrow up to 80% of a home’s appraised value. For example, if your home appraises at $300,000, you can borrow up to $240,000. So if you owe $200,000 on your mortgage, in theory you can borrow $40,000. Nowadays lending standards are a bit stricter though, so the amount you’re allowed to borrow is going to be closely tied to your credit rating and current outstanding debt.
Now before you run to the bank to sign up for one of these loans, remember that both a HELOC and home equity loan use your home as collateral. Just like a mortgage, failing to make payments could put your home at risk. So always make sure you can comfortably handle the monthly payments before signing on the dotted line.
I had a line of credit for 25 years. I converted it 2 years ago, because of the difference in interest rates. I only use it occasionally, but I like the availability.
My story: Found a triplex. Ran the calculations. Discovered that, assuming a 5% (or even a 6.5%) interest rate, the monthly mortgage payment + insurance + property tax + projected repairs + projected vacanies + margin of error would STILL be lower than the monthly rent collected.
So I took out a Home Equity Loan, at 5%, and bought the triplex with it … thus investing the equity into something that will actually put cash in my pocket every month.
The appeal of both of these types of loans is their interest rates, which are almost always lower than those of credit cards or conventional bank loans because they are secured against your home. In addition, the interest you pay on a home equity line or loan is often tax deductible (consult a tax advisor about your particular situation). Generally, a HELOC is a good choice to meet ongoing cash needs, such as college tuition payments or medical bills. A HEL is more suitable when you need money for a specific, one-time purpose, such as buying a car or a major renovation.