If you have owned your home or several years, you have likely built up some equity. Simply put, the amount of equity you have is the difference between what your home is currently worth and how much you still owe your mortgage lender. When you have equity in your home, you can opt to take out a home equity loan or a home equity line of credit. Before borrowing against the equity in your home, it is important to understand both options and when to use them.
Home Equity Line of Credit (HELOC)
A HELOC is a revolving line of credit, similar to a credit card. When you’re approved for a HELOC, you will be notified of how much credit you have available to use, which often equals the amount of equity you have. You will be able to access this money and use it as needed for a set amount of time, such as five or 10 years. A HELOC has a variable interest rate and as you repay the money you spend you will start by making interest only payments.
Some of the benefits of HELOC include the fact that the interest payments you make are tax deductible, and you can easily access the money by using a debit card connected to the account or by writing a check.
Home Equity Loan
Home equity loan definition: a loan of a predetermined amount issued by a lender based on the amount of available equity you have in your home. If a HELOC is similar to a credit card, you can think of a home equity loan as kind of like a mortgage loan. When you’re approved for a home equity loan, you will receive a lump sum of money, a fixed interest rate on the loan, and a set amount of time to repay the loan.
Like a HELOC, interest payments made on a home equity loan are also tax deductible. Another benefit of a home equity loan that many people appreciate is that payments remain the same since the interest rate is fixed.
When to Use a HELOC or Home Equity Loan
If you’re planning on applying for a HELOC or a home equity loan, it is important to use the funds responsibly so you don’t end up having to pay back a large amount of money with nothing to show for it. It is recommended that homeowners use funds from a HELOC or home equity loan in the following situations:
- Home Improvements: One of the more common reasons homeowners take out a HELOC or home equity loan is in order to make improvements to their home, such as remodeling a bathroom or kitchen. This is usually a good use of funds since home improvements can add value to the home and provide a good return on investment.
- Higher Education: Whether you want to go back to college or help one of your children pay for college tuition, a HELOC or home equity loan is a reasonable way to help cover those expenses. Higher education is a good investment that will help a person increase his or her earning potential over a lifetime.
- Emergencies: While it is a good idea to have an emergency savings account, there may be emergency situations where you may need to access a large amount of money in a short amount of time. If you want a financial cushion against potential emergencies, choose a HELOC. The money will be there if you ever need it, and if you don’t you won’t incur any debt.
A good rule of thumb is to avoid taking out a HELOC or home equity loan for things that are not a good investment or depreciate in value. Cars, recreational vehicles, and vacations are all good examples of what not to use a HELOC or home equity loan for.