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  • Posted October 8, 2018

Home Equity Loan or HELOC? What’s the Difference?

Let’s start with when you should, and shouldn’t use either or both. If you are drowning in credit card debt and think this is a great way to get out – don’t (general rule). If you don’t change habits you’ll be right back where you are now in short order. This is a good general rule to follow for any debts, don’t pay them off through leveraging your house – it puts too much at risk. If, however, you want to update, renovate or other major home projects – either could be a great way to do so.

Home equity loans are lump sums of cash lent to the borrower based upon the value of the home when the loan is applied for. Generally this will not exceed 85% of the home’s value, which gives a little buffer in the event valuations drop and your home loses value – you may not immediately find yourself underwater. You and the lender will agree on a fixed interest rate (won’t change over the life of the loan) and the number of years to pay it back. The payment schedule is fixed, you need to make every loan payment on time or risk penalties.

A HELOC is a home equity line of credit – it works similar to a credit card. A credit card has a fixed limit you can use, so does a HELOC. You can borrow as little or as much as you need to up to this limit, although you’ll be charged interest on any outstanding balance. There is a key difference between a HELOC and credit card though – with HELOCs you will only have this line of credit available for a fixed period of time (usually 10 years). When this expires you will need to pay it back, plus interest – and you may not be able to get another HELOC until it’s paid off (will depend on the lender).

HELOCs have variable interest rates, so your payments may increase – especially when interest rates are rising. It’s important to know which benchmark the line of credit is tied to, this will give you a heads up if interest rates are coming. Each lender will have their own rules and/or minimums – for example you may need to use at least $5k when you first open it and at least $2,500 every time you access it going forward (values made up for illustrative purposes).

These are NOT “free” money! When borrowing against your house, you are giving the lender permission to take the house from you if you don’t pay your bills (loan payments). You are also required to pay these back in full if you sell your house – so if you have a mortgage and one of these, think about how you will put a down payment on a new home.

They do have a place, the interest is still tax deductible (2018) if used for home improvements. And if you’re a responsible lender a HELOC could be a great back-up to your emergency fund (not a replacement); or a place-holder while you save towards your emergency fund. If you’re considering one take into consideration what the payments will be and if you can reasonably afford them, especially HELOCs – interest rates won’t stay low forever and you don’t want to get caught off guard. Consider working with an Financial Advisor/Planner, get an impartial opinion about the impact on your financial wellness and ability to accomplish goals.