Home Equity Loan Versus Line of Credit: Pros and Cons

Managing Your Mortgage, Mortgages
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Home Equity Loan Versus Line of Credit: Pros and Cons

Selling your home for a profit can mean a substantial windfall. But in the meantime, while living there, that gain is locked up, out of reach — unless you access the equity with a loan or line of credit.

A home equity loan, or a line of credit, is drawn on the value of your home above and beyond what you owe on your primary mortgage. Weighing the pros and cons of each will help you decide which one is right for you.

Keep in mind that it’s a common point of view among financial planners that the only acceptable reason to tap the equity of your home is for things that will increase its value. Consider that as you assess the characteristics of home equity loans versus lines of credit.

>> MORE: Find the best loan to finance your home improvement project

Accessing the value in your home

The days of lenders allowing you to borrow against 100% of your home’s value are all but over. That was a contributing factor to the 2008 housing crash and since then, lenders have become more prudent.

The amount you owe on outstanding home loans divided by the market value of your home is considered the combined loan-to-value ratio (CLTV). If that ratio is high, lenders will hesitate to let you borrow more against the home’s value. Typical CLTVs these days run in the 70-80% range though some lenders may go higher, depending on your creditworthiness.

An example: Your home is worth $300,000. You owe $150,000. If you divide 150,000 by 300,000 you get .50. You have a 50% loan-to-value ratio. A lender that allows a combined loan-to-value ratio of 80% would grant you a 30% home equity loan or line of credit, for $90,000.

Now, to the differences between the two options.

Home equity loan

Commonly referred to as a second mortgage, a home equity loan is simple enough: It’s a lump sum one-time equity draw.

Usually structured with a fixed interest rate, a home equity loan is a good source of funds for major projects and one-time expenses. And because the interest rate is locked in, it’s easy to budget for a regular monthly payment. Remember, that loan payment will be in addition to your usual mortgage payment.

  • PRO: A fixed interest rate
  • PRO: Interest paid is usually tax deductible
  • CON: Tapping the equity in your home in one fell swoop can work against you if property values in your area decline

Home equity line of credit

Called a HELOC (HEE lock), a home equity line of credit allows you to draw funds as you need them, via a debit card or by writing checks. It’s a convenient way to pay for ongoing projects or for multiple cash needs. You’ll pay interest only on the amount you draw.

HELOCs often begin with a lower interest rate than home equity loans but feature variable rates, which rise or fall according to the movements of an interest rate benchmark. That means your monthly payment can rise or fall, too.

Many HELOCs also allow interest-only payments during the initial draw period, after which principal and interest payments are required. When the repayment period begins, no further draws on the line of credit can be made.

And term-limited home equity lines of credit can mature, with the remaining balance plus accrued interest becoming immediately due, for example at the end of 10 years.

  • PRO: Pay interest compounded only on the amount you draw, not the total equity available in your credit line
  • PRO: Flexibility of interest-only payments during the draw period
  • PRO: Interest paid is usually tax deductible
  • CON: Rising interest rates can increase your payment
  • CON: Without discipline, you might overspend, tapping out the equity in your home and leaving yourself faced with large principal and interest payments during the repayment period

Terms and characteristics of home equity loans and lines of credit vary from one lender to another. Be sure you understand the repayment terms of your loan before you commit to a lender, and don’t be afraid to shop around before you sign on the dotted line.

The bottom line

Using the equity in your home before selling can be a powerful financial benefit. But remember, you are using your home as collateral. One risk to avoid, whether you choose a home equity line of credit or a loan: Resist funding short-term needs with what may eventually amount to a long-term loan.

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Hal Bundrick is a staff writer at NerdWallet, a personal finance website. Email: hal@nerdwallet.com. Twitter: @halmbundrick


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