With their low interest rates, home equity loans and lines of credit can be an effective way to borrow money. Home equity loans or lines of credit of up to $100,000 often offer the added benefit of being tax deductible (check with your tax advisor). But it’s important to remember that these loans are secured by your home and should be sued wisely.
Financing a renovation that will add value to your home, such as a new kitchen or a second bathroom, or helping with your child’s college tuition, are valid reasons to borrow on the strength of your home equity. This is especially true since the borrowing costs are generally much less expensive than debt that is not secured by collateral.
By the same token, shifting hefty balances you owe on credit cards to a home equity loan can be a good move. Your credit cards are likely charging annual interest of 13 percent or more, so consolidating that debt with a home equity loan can easily slash your borrowing costs in half.
Remember though, the idea is to eliminate your debt, not make room for more of it.
A home equity loan isn’t free money. At the end of the day, your home is what’s backing the loan. So if you miss payments, the lender could take possession of your home.
There are also important differences between a home equity line of credit and a home equity loan -- differences that can help you determine which is a better choice for you.
Home equity line of credit
A home equity line of credit (HELOC) allows you to use as much or as little of your pre-approved limit as you like. Plus, you are charged interest only on the portion of credit you are currently using, which keeps borrowing costs low. The rate of interest floats slightly above the prime rate.
This flexibility is helpful if you’re looking to do a series of small home renovations over a long period of time, or perhaps finance the start-up of a home-based business.
- The advantage: If the prime rate decreases, your cost of borrowing will become cheaper, and interest rates are still very low compared to previous decades.
- The disadvantage: If the prime rate increases, your borrowing costs will increase as well. If you find it difficult to squeeze in credit-line repayments now, you may risk missing some repayments altogether when interest rates go up.
Also, depending on the terms of your particular HELOC, you may be required to pay only the interest accrued each month. On the upside, this means your minimum payments will be low during the interest-only period. On the downside, you will not be rebuilding any of that valuable home equity you’ve just borrowed against.
When the interest-only period ends, you will be faced with one of two scenarios. You may be required to begin paying back the loan principal (the original amount you borrowed). That means your monthly payments will increase, and if you don’t have enough cash coming in to cover those larger payments, you could be in trouble. Or you may be facing what’s called a balloon payment, meaning you must pay the entire outstanding balance of your HELOC in full.
Always try to pay more than the minimum each month, so you are constantly chipping away at your loan principal.
Home Equity Loan
A home equity loan has a fixed interest rate. You receive the full amount of the loan in a lump sum, which makes it a good choice for large, one-shot expenses, such as a home renovation or debt consolidation. And because you must pay it back in regular increments over a specified period of time -- often 10 to 15 years -- a home equity loan offers a measure of built-in discipline for those who may be tempted to use the “interest-only” payment option offered by some HELOCs.
At the end of the repayment schedule, a home equity loan will be repaid in full.
The general rule is you can borrow 75 to 80 percent of your home’s current appraised value, minus what you owe on your first mortgage. This is called the loan-to-value ratio (LTV). For example, if your home is worth $200,000 and you owe $100,000 on your current mortgage, you could borrow an additional $60,000 and still be within an LTV of 80 percent. Staying within the sensible 75 to 80 percent range will help you avoid repayment problems down the road. Some lenders may offer a “high-LTV” option in which you can borrow up to 125 percent of your home’s equity. Beware: If you decide to move because of a job transfer or other reasons, the sale of your home may not provide you with enough money to pay off both your mortgage and the outstanding home equity loan.
Borrowing conservatively is always wise.