Understanding the difference between a home equity loan and a line of credit is important when choosing which type of loan to use.
Both loans are secured by your home equity, but the way you borrow money is different with each.
A home equity loan is a lump sum of money that you borrow all at once and pay back over time with fixed monthly payments.
A home equity line of credit (HELOC) allows you to borrow money as you need it. You can use as much or as little as you want, and you only pay interest on the amount you borrow.
Read on to learn more about each option so you can choose the best one for your financial needs.
When you should get a HELOC
If you want to borrow money as you need it and only pay interest on the amount you borrow, a HELOC might be the right option for you.
A HELOC is a line of credit that is secured by your home equity. You can use a HELOC for any purpose, such as consolidating debt, making home improvements, or investing.
The main advantage of a HELOC is that you only pay interest on the amount of money you borrow. You also have the flexibility to use as much or as little of the credit line as you need, like a credit card, and you can draw on the line of credit for up to 10 years.
How does a HELOC work?
A HELOC is a new loan that you’ll apply for with a lender, that’s based on your home’s value. A HELOC is a separate line of credit on top of your primary mortgage.
HELOCs don’t affect your mortgage in any way and come with very low closing costs compared to cash-out refinances. They also often don’t require an appraisal.
To get a HELOC, apply with a lender and they’ll determine your approval for the maximum loan amount based on a percentage of your home’s value. The lender gives you a credit line that you can access as needed up to the maximum amount.
You only pay interest on the amount of money you borrow, and you have up to 10 years to repay the loan. At the end of the 10-year period, you can either renew the loan or pay it off in full.
What is a home equity loan?
A home equity loan is a type of second mortgage loan that you’ll take on in addition to your existing one. They won’t change anything about your current mortgage.
Similarly to other options, this loan allows homeowners to borrow against the equity in their homes. But a home equity loan is paid out in a lump sum whereas a HELOC allows the borrower to only borrow what they’re going to use, or “borrow as you go.”
Additionally, many lenders will only allow you to borrow around 80% of your home’s equity with this loan. That will also depend on your credit and finances.
What about a cash-out refinance?
If you want to borrow a lump sum of money and have equity in your home, a cash-out refinance might be the right option for you.
With this type of refinance, you refinance your existing mortgage for more than you currently owe and take the difference between your existing mortgage and your home’s value in cash.
You can use this cash for any purpose, such as home improvements, consolidation of other debts, or investment.
The main advantage of a cash-out refinance is that you can take advantage of the equity you’ve built up in your home. You can also choose to lock in a lower interest rate if rates have gone up since you originally obtained your mortgage.
How a cash-out refinance works
A cash-out refinance is a new loan that pays off your old mortgage and gives you extra cash to use as you see fit. To get a cash-out refinance, you need to have equity in your home — this is the difference between what your home is worth and how much you still owe on your mortgage.
HELOC vs. cash-out payment examples
Let’s say you have a $200,000 home with $150,000 owed still on your mortgage. That means you have $50,000 in equity.
If you get a cash-out refinance for $250,000, you can use the extra $100,000 to pay off debt or make home improvements.
If you get a HELOC for $50,000, you can use the money as you need it and only pay interest on the amount you borrow. If you only use $25,000 of the credit line, you only pay interest on $25,000.
HELOC vs. cash-out refinance: Pros and cons
The main advantage of a cash-out refinance is that you can take advantage of the equity you’ve built up in your home. You can also choose to lock in a lower interest rate if rates have gone up since you originally obtained your mortgage.
The main disadvantage of a cash-out refinance is that you are resetting the clock on your mortgage. You will have to start making payments all over again, and you could end up paying more interest over the life of the loan if rates have gone up since you originally obtained your mortgage.
Another disadvantage is that it can be difficult to qualify for a cash-out refinance if you have poor credit. Not to mention that your house is basically used as collateral in the event of a loan default.
The main advantage of a HELOC is that you only pay interest on the amount of money you borrow. You also have the flexibility to use as much or as little of the credit line as you need, and you can draw on the line of credit for up to 10 years.
The main disadvantage of a HELOC is that your home equity is at risk if you don’t repay the loan. If you can’t repay the loan, the lender could foreclose on your home.
Another disadvantage is that HELOC rates are variable and could increase over time, which would increase your monthly payments.
If you’re not sure which option is right for you, speak to a lender to get advice on which option would be best based on your individual circumstances.
Tax deductibility
Mortgage interest is tax-deductible, but there are limits on how much you can deduct.
For a cash-out refinance, you can deduct the interest on up to $750,000 of debt. For a HELOC, you can deduct the interest on up to $100,000 of debt.
If you’re using the money for home improvements, you may be able to deduct the interest even if you exceed the $750,000 or $100,000 limit.
This is definitely something that you should discuss with both your lender and tax preparer.
Should you get a HELOC, home equity loan, or a cash-out refinance?
Now that you understand the difference between a HELOC and cash-out refinance, you can start to compare options to see which one is right for you.
Some things to compare include:
- Interest rates. Compare the APR on each loan to see which one has the lower rate.
- Fees. Make sure to compare any origination fees or other fees charged by the lender.
- Terms. Compare the terms of each loan to see which one has a longer repayment period and lower monthly payments.
- Tax deductibility. If you’re planning to use the money for home improvements, make sure to compare the tax deductibility of each option.
If you’re looking to refinance but are put off by the high-interest rates, crunch the numbers between a refinance, home equity loan, and a HELOC to see which one is the better deal for you.
Additionally, a cash-out refinance is a good idea if you know that your home has significantly increased in value.
Once you’ve compared all the options, you can make an informed decision on which loan is right for you.
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