Borrowing against the value of your home generally takes one of two forms: a home equity loan or a home equity line of credit. While both terms are often tossed around interchangeably, they are distinct forms of debt and it is important to understand the differences between the two.
Equity loans give you a specific amount of money in a single lump amount. These loans are perfect when you are undertaking a large, defined project such as home improvements. With this type of debt you have a set repayment schedule, making it easier to budget for repaying the loan.
So what is a home equity line of credit? Unlike a loan, a home equity line of credit (also known by its acronym HELOC) provides a flexible amount of money over a period of time. Like a credit card, HELOCs provide a line of credit that you can access whenever you need the funds.
The main advantage of a line of credit is that you only pay interest on the funds you have withdrawn. For example, you might get a HELOC for $50,000. But if you only withdrew $10,000 from it, you would only pay interest on that amount, rather than the entire $50,000. Another advantage is that there are often no closing costs.
The downside to HELOCs is that, unlike a home equity loan's fixed rate, the interest rate is usually variable. As interest rates increase, so too do the costs of your loan, sometimes dramatically. If you think interest rates will be going up in the future, as many experts do, it may not be wise to take out a huge HELOC.
Another downside is that your credit and income will be reviewed every few years to see if you can afford to keep the line open. If your credit score drops, your bank could close out your line of credit.
At one time, HELOCs offered low teaser rates, which made them extremely attractive. However, in today's market the rates for both types of debt are fairly similar.