With home prices soaring in recent years, you’re likely sitting on more equity in your home than ever before. So how do you choose the right home equity product to help finance that kitchen makeover, bathroom renovation, or room addition?
Here’s some helpful information on choosing a home equity loan versus a home equity line of credit. But before that, let’s quickly cover the basics of home equity.
What is Equity?
Equity is essentially a dollar amount that can be found by subtracting the current property value of your home from your current mortgage balance.
For example, if your home is worth $250,000 and you owe $100,000 on your mortgage, you would have a $150,000 equity stake in your property. Your equity goes up and down as property values fluctuate and as you pay down your mortgage and other home-backed loans.
Home Equity Loans
A home equity loan – sometimes called a HELOAN – is a closed-end loan that typically offers a set interest rate throughout the life of the loan.
Like a traditional installment loan, you have one lump sum to use that is given upfront and paid in equal payments over the life of the loan. Once the loan is paid off and the repayment period ends, the loan is closed and you would need to reapply for a new one if you wanted.
Home Equity Line of Credit
However, you do have a set amount of time you can use the line – this is known as the “draw period” and is typically 10 years, during which you can only make interest payments.
After this period expires, you enter the repayment period. This typically lasts between 10-20 years and you are responsible for principal plus interest payments. Once the credit line is paid in full and the repayment period ends, the line is closed and you would need to reapply for a new HELOC if you wanted.
How to Choose
As you can see, both have their advantages and disadvantages. The right one for you depends on your financial situation and needs.
For large, one-time expenses such as a bathroom remodel, a home equity loan is likely the way to go. However, for multiple projects spread out over time, a home equity line of credit might be better.
It’s also good to know that while most people use both types of products for home-related expenses, you can often apply the funds towards whatever you need, even a wedding or dream vacation. Just check the fine print to see what usage restrictions may apply, if any.
Like any credit product, your credit score is impacted, so be sure to make payments in full and on time while in the repayment period.
It’s also important to note that both are backed by the collateral in your home. This means you typically get larger credit limits and lower interest rates, but your house could be at risk in the event you default on the loan.
With this in mind, it’s extremely important to budget and make sure this is a financial responsibility your household can maintain. Your banker can discuss specific requirements as far as credit score and equity owned when you visit the bank to discuss your options. Debt-to-income requirements typically apply as well, so there’s a handy calculator below to help you see where you currently stand.
Because of potential tax breaks and implications, it’s also a good idea to talk to your financial or tax advisor, too.
Whether you choose a home equity loan or HELOC, remember that your bank is here to support you. Both products can help you take advantage of your home’s equity in their own way.
OMB and its affiliates do not provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decision.
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