A home equity loan or line of credit (HELOC) allows you to borrow money using your home’s equity as collateral. This is like a second mortgage that turns equity into cash.
To begin, let’s make sure we understand these two important terms:
Collateral is something that you pledge will repay a debt. If you don’t repay the debt, the lender can take your collateral and sell it to get its money back. With a home equity loan or line of credit, you pledge your home as collateral. You can lose the home and be forced to move out if you don’t repay what you’ve borrowed.
Equity is the difference between how much the home is worth and how much you still owe on the house.
If Your Home Value Goes Up
Let’s say you buy a house for $150,000. You make a down payment of $20,000 and borrow $130,000. The day you buy the house, your equity is the same as the down payment: $20,000.
Fast-forward five years. You have been making your monthly payments faithfully, so you now owe $117,000. During the same time, the value of the house has increased. Now it is worth $200,000. Your equity is the difference between them: $83,000
If Your Home Value Goes Down
Let’s say you buy a house for $150,000. You make a down payment of $20,000 and borrow $130,000. In five years your balance is $117,000.
But home prices fell. Now your home is worth $105,000. But you still owe $117,000. Because the value of your home is less than the amount you owe, you have negative equity and are not eligible for a home equity loan.
Types of Home Equity Debt
There is a difference between home equity loans and home equity lines of credit. Both are called second mortgages because they are backed by your property. Home equity loans and lines of credit are repaid in a shorter period than first mortgages. Mortgages are set up to be paid over 30 years. Equity loans and lines of credit often have a repayment period of 15 years. Sometimes it is as short as five and as long as 30 years.
A home equity loan is a lump sum that is paid off over a set amount of time. There is a fixed interest rate and the same payment amounts each month. Once you get the money, you cannot borrow further from the loan.
A home equity line of credit works like a credit card. It has a revolving balance. A HELOC allows you to borrow up to a set amount for the life of the loan. During that time, you can withdraw money as you need it. As you pay off the principal, you can use the credit again like a credit card. A HELOC gives you more options than a fixed-rate home equity loan. You can remain in debt with a home equity loan. This happens if you pay interest and not the principal.
Terms and Repayment
A line of credit often has an interest rate that changes over the life of the loan. Payments vary based on the interest rate. You can’t add new debt during the repayment period. You must repay the balance over the remaining life of the loan.
The draw period often is five or 10 years. And the repayment period often is 10 or 15 years. But each lender can set its own draw and repayment periods. A customer’s check, credit card or electronic transfer accesses a line of credit. Lenders often have some requirements:
- Take an initial advance.
- Withdraw a minimum amount each time you dip into it.
- Keep a minimum amount outstanding.
With either a home equity loan or a line of credit, you must repay the loan in full when you sell the home.