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What's the Difference Between a Home Equity Loan & a HELOC?

Bev O'Shea

If you have a mortgage and some home equity, you may wish you could somehow tap into that equity to pay bills — particularly when you have a big expense. And in many cases, you can.

Occasions when you might want to do that include: paying college tuition, buying new home appliances, paying for a home remodel or consolidating credit card debt into a single loan with a lower interest rate.

To figure out how much equity you have, subtract the amount you owe on your home from the home's value (a site such as Zillow can help you make an educated guess). If your credit is good, a financial institution may even allow you to borrow up to 80% — or even 90% (but at a higher interest rate) of your home's value. You can check your credit with Credit.com's free credit report summary, which includes two scores, updated every 30 days.

There are a couple of ways to borrow against the value of your home, and you may hear the words "second mortgage" applied to both of them. Although they work differently, home equity loans and home equity lines of credit, or HELOC, both use your home as collateral, much as your original mortgage does. And like your original mortgage, they will need to be repaid if you sell your home.

The biggest difference between a home equity loan and a home equity line of credit is the home equity loan is an installment loan (like a car loan) where you make a fixed payment for a set period of time in order to pay it back. A home equity line of credit is revolving credit (like a credit card); once you repay what you owe, your credit limit is once again available to you. Both kinds of financing are secured by your home, and in most cases you'll need at least 20% equity to qualify for the lowest rates. (The rate you get also depends on your credit score, with a better score getting the better terms.) Another attraction of these options is that you can often write off the interest on your taxes. It is important to understand that when you use your home to secure a loan, if you should default, your home could be foreclosed on, even if your original mortgage is in good standing.

Choosing Between the Two 

There is no hard-and-fast rule about when to use which type of financing. But in general, if something has a known, fixed cost, you may want to choose a home equity loan that will cover it. That way, you'll know for certain exactly how long you'll be paying and what your payments will be. Some people use these loans to consolidate credit card debt (if you do, make sure the problem that caused the debt has been addressed, and be sure you're comfortable replacing unsecured debt with debt secured by your home) or to pay for a bathroom remodel.

A home equity line of credit may be used to pay bills associated with a medical emergency or a recurring bill, like tuition payments. Or you could use it for a home remodel that you're paying for in stages. Its flexibility makes it especially useful if you're not sure what the total amount you'll need to borrow will be. A home equity line of credit typically has a time-limited "draw period" during which you can withdraw money against your home equity, and adjustable interest rates (that may at least start out lower than a comparable home equity loan), and you may only have to repay interest during the draw period, However, that feature can also make overspending a temptation. And when the draw period ends, the principal must be repaid. (At that point, some people refinance into a home equity loan, if that option is available.)

Whichever you choose, be sure you understand all the terms and conditions beforehand. It's not the most exciting reading, but it can prevent unpleasant surprises later.

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