Home Equity Loan and Home Equity Line of Credit Basics

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Home equity loans and home equity lines of credit (HELOCs), are lending tools that allow you to borrow against the equity in your home. Such loans are often used to improve your home, pay for college, make large purchases, or meet certain expenses. In recent years, stricter lending standards meant fewer home equity loans and HELOCs were approved. However, a March 2013 report from Equifax found that 2012 was the first time since the recession that home equity revolving lines increased, although the $65.5 billion in such loans taken out in 2012 is roughly a third of the amount taken out in 2006.1

Article Highlights

  • Home equity borrowing is increasing.
  • Home equity loans and lines of credit can be valuable cash management tools.
  • Understanding the best use of each is important to maintain your financial security.

An uptick in home equity-based lending is good news for homeowners. Secured by real estate, these loans usually have lower interest rates than credit cards or personal loans. That makes them a useful tool for covering large expenses, such as home improvements or college tuition. However, using them effectively as part of a broader financial plan requires understanding the answers to a few key questions.

What is the difference between a home equity loan and a HELOC?

Both home equity loans and HELOCs are loans made based on the equity in your home – the value of your home less the amount financed. Home equity loans are structured so the borrower receives a lump sum and payments are made over a predetermined period of time. HELOCs, on the other hand, allow the borrower to access a specific amount of credit on an as-needed basis, usually by writing checks issued for the line of credit. HELOCs have a limited time during which the borrower can take advances on the credit line called a “draw period.” There is a minimum amount due based on the outstanding balance while the draw period is active. When that period is over, the remaining balance is typically converted into amortizing payments at a fixed or variable rate of interest for repayment over a period of time similar to a home equity loan.

When and how should these loans be used?

Borrowing against the equity in your home can be a powerful tool, but it’s one that should be used strategically and carefully. Use home equity loans and HELOCs to pay off high-interest debt or tax obligations, improve your home, make tuition payments, or purchase big-ticket items like automobiles at a more favorable interest rate. It’s typically not a good idea to use them to meet everyday expenses or “splurges” like vacations.

Home equity loans are usually best for one-time purchases where you know the amount you’re going to need. For example, if you plan to add a room onto your home, you might opt for a home equity loan to finance it, allowing you to make fixed payments at a lower interest rate than other types of financing.

HELOCs are generally preferred when the borrower needs periodic access to funds, such as making a tuition payment or making an unexpected home repair. It’s best to use this for specific reasons and pay down as much of the balance as soon as possible, just as you would on a credit card. Every time you borrow against the equity in your home, you’re extracting money from the return you’ll get on the home if you ultimately sell it. Also, by securing the loan with real estate, you are pledging and putting at risk your residence if the payments can’t be made.

Will my home equity loan or HELOC interest be tax-deductible?

Another advantage of using home equity financing is that the interest may be tax-deductible, provided you meet certain criteria. Since there are various restrictions on deductibility based on tax filing status, ownership interest in the property, the amount financed, and how the funds were used it is recommended that you consult a tax advisor regarding the potential tax implications of this type of borrowing. IRS Publication 936 fully explains the particulars of home equity debt deductions.

How do I qualify for a home equity loan or HELOC?

Qualifying for a home equity loan or HELOC is similar to qualifying for a conventional mortgage. You’ll be asked to fill out an application and provide proof of income, assets and expenses. Be sure you review your credit reports with all three major credit reporting agencies (Equifax , Experian , and Trans Union ) before you apply to get a sense of your credit scores and ensure that there are no errors that could cause you to be denied. Then, look at your overall debt ratio and pay down as much as you can. Tip: For a free copy of your credit report from each of the three major credit reporting agencies visit AnnualCreditReport.com .

The value of your home is another critical factor in determining whether your loan or line of credit will be approved. In most cases, the amount of all loans and credit lines on a property — including first and second mortgages, home equity loans, and home equity lines of credit, and any other outstanding liens — cannot exceed 80% of the current property’s market value. Any lender will likely order a real estate appraisal to determine the current market value of your home before approving the loan. If you obtain a HELOC, it's possible that your home equity line may change over time, depending on fluctuations in the value of your home and the overall market conditions.

You’ve worked hard to build equity in your home. Home equity loans and HELOCs are tools that can make that equity work for you when you need to make big purchases or cover large expected or unexpected expenses. Work with a reputable loan advisor to choose the best option for your needs.

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