What's the difference between a home equity loan and a line of credit?

There might be many instances in your life where your savings won't be enough to pay for your debts or cover a large purchase. When this happens, as a homeowner, you will have two possibilities to help your financial situation, a home equity loan or line of credit. Both of these options will depend on your home equity and allow you to tap into a limited amount of funds if you want to know which one will be better for you. Here we will explain the difference between home equity loans and line of credit.  

Before we go ahead and look into the difference between a home equity loan and a home equity line of credit, first, you need to understand what home equity is and how to calculate it. Home equity is significant because this factor will determine how much you will be able to borrow.

Home Equity: How to calculate it

To understand home equity think about it as the part of the property you own. If you get a mortgage to purchase your property, while you start paying the balance, your home equity will increase. Home equity is also one of your most valuable assets since it can help you get loans or credit lines.

In case you want to calculate your home equity at the moment, here is how you do it. Take the current value of your property and subtract what you still owe from the mortgage. Keep in mind that even though most lenders will allow you to borrow up to 85 percent of your home equity, the funds will also depend on your credit history. 

Also, whenever you apply for either a line of credit or loan, all lenders will take into account your loan-to-value ratio. You can find out this ratio, summing up what you owe and dividing it by the value of your property.  

Now that we understand the concept of home equity. We will look at the difference between a home equity loan and a home equity line of credit. 

Home Equity Line of Credit

A Home Equity Line of Credit (HELOC) is also known as revolving credit. This means they are similar to a credit card. With a HELOC, you will be able to borrow money up to a limit. Then, once you start paying your balance, your funds will be freed up. Your minimum payments can change depending on how much money you decide to take out because of how the HELOC works. 

A HELOC is a secured line of credit, which means you will need to put an asset as collateral, in this case, your home. A HELOC is useful if you have a large amount of equity, which allows you to borrow more money. However, if you miss several payments, your lender could seize your property. 

Many people tend to use the funds they borrow for renovations, or in some cases, to buy a second property. Even though in the latter scenario, we recommend always using a HELOC. Your lender will give you the option of choosing between a HELOC and a mortgage. To learn more about this, visit the link.

How a HELOC works

Once your HELOC is approved, there will be two phases. At the beginning, which often lasts up to ten years, you will be in the draw period. During this time, you will be able to access the funds up to a limit or cash out what you need at the moment. In this draw period, you will also have to make interest-only payments. But, you will have the option of paying more and contributing it to your borrowing amount.

After, you will enter the repayment period. For a HELOC, this will last for 20 years. Here you will have to cover all the amount you borrow, the reason why your payments might double. The repayment method and timeline might vary depending on your lender.

Home Equity Loan

These are also known as second mortgages, but in reality, they are fixed-term loans that depend on the amount of home equity you have. A loan, as you might know, is approved for a set amount. In this case, you will receive the money upfront. With a home equity loan, you will have a fixed interest rate, similar to the one you will find in a mortgage. 

Every month, you will get a bill with the same amount when it comes to the payments. A portion of what you pay goes for the interest and another for what you owe. This loan can last anywhere from 5 to 30 years, but that will depend on your lender. Taking out a home equity loan 2nd position will be the only way to get cash out above 80%. Such a loan is less risky for the lender, and because of that, you can expect lower interest rates.

How a Home Equity Loan works

Before applying for a home equity loan, make sure to check your credit score, have a copy of your employment history and a stable income. After you get the Home Equity Loan, you will receive the whole amount you ask for. This is great if you need to make one big purchase, such as a renovation. Then you will start repaying at a fixed rate the amount you borrowed. 

What is the difference between a home equity loan and a home equity line of credit?

Since both options seem like a great choice when you are out of cash, many people wonder what the difference is between a home equity loan and a line of credit. To help you out, here are some aspects to look out for.

1. Interest Rate

You might have noticed that the main difference between a home equity loan and a home equity line of credit is the interest rate. While a loan offers a fixed interest rate with a line of credit, this factor can change. This means that with a line of credit, your payments will increase. 

2. Payments

In a loan, you will agree with your lender to make a set monthly payment for a determined amount of time from the very beginning. The advantage of a line of credit, in this regard, is that during the draw period, your lender might offer you some flexibility. 

3. Funds you cash out

As we mentioned before, a line of credit functions like a credit card; this means you have a limited amount, and you can only use what you need. This is a great benefit since you will only pay interest for what you borrowed. In a loan, you will have to repay the whole approved amount. 

Related Article:

• Getting to Know Home Equity Loans for Toronto Residents
• Different Types of Loans & Useful Financial Tips to Fully Understand Them