You can use your home's equity as collateral to borrow money in one of two common ways. A home equity loan is an installment loan similar to your first mortgage. A home equity line of credit, or HELOC, is a credit line made available with your home equity as collateral. Each approach has pros and cons.
Home Equity Loan Pros
Your home's equity is the difference between its market value and your loan balance. You build equity with your initial down payment and by making principal payments over time. A simple equity loan works similarly to your first mortgage. Since the loan is secured by your property, you get a much better interest rate than you would on a personal loan. The interest is usually similar to your mortgage rate. For this reason, it makes a lot of sense to use an equity loan when you want to borrow a fixed amount for home renovations, college or to start up a business.
Home Equity Loan Cons
An equity loan does have some downside. The most significant drawback is you add another lien against your property, increasing your potential for loss. Specific to the loan, you increase the amount of monthly payments you have to make on home loans. Since it is amortized and repaid over time, an equity loan includes principal and interest balances each month. An equity loan also reduces your equity stake in the home, which means you would get less money out of the home if you sell before repayment is complete. Because of its risks, using equity as collateral for non-essential or luxury purchase is ill-advised, according to Broderick Perkins of legal website NOLO.
HELOCs have some important advantages compared to an equity loan. Rather than a lump-sum installment, the bank grants you use of a credit line with a limit, similar to a credit card. Your interest rate is typically variable based on market factors. Along with a good interest rate, a HELOC has flexibility. You only borrow money on the account as needed. It makes more sense if you have projects with undefined budgets, or need to borrow incrementally over time, such as when paying for college.
HELOCs may be too risky if you aren't a disciplined spender. If you tend to overuse credit card limits, you would likely do the same with a HELOC. Another drawback of a HELOC is that you normally pay only interest during the initial draw period of five to 10 years. During this period, you can use the credit as needed and only have to pay interest each month on the balance. After the draw period, the remainder is amortized like an equity loan or mortgage. This makes HELOCs really costly if you maintain a high balance and only pay the interest.
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