If you need money to pay for an expensive medical bill or to remodel your house, tapping into the equity of your home could be a solution.
A home’s equity is the difference between what your home could sell for and what you owe on the mortgage. You have two options to finance a major expense using your home’s equity as collateral: You can take out a home equity loan or a home equity line of credit.
There are positives and negatives that come with both home equity financing options, says Peter Ashby, a financial planner with the Financial Planning Association.
With a home equity loan, the lender advances you a total lump sum upfront with a fixed interest rate. With a home equity line of credit (HELOC), you are allowed to take out money as you need it, but there is a cap on how much you can borrow—similar to a credit card.
If you take out a home equity loan, you’ll be responsible for repaying the loan in regular installments—monthly, for example—over a specific period of time. You’ll have the security of knowing exactly how much you borrowed and how long it will take to pay it all back. This can make it easier for the borrower to budget. But whether you use all of the money or not, you'll be paying interest until the loan is paid off.
With a home equity line of credit, even though there’s a cap on how much money you can borrow, there is a little more flexibility, Ashby says. You can borrow based on what you need at any given time, and you will only pay interest on what you’ve taken out.
However, home equity lines of credit can be affected by an unsteady economy.
“In 2009 when credit started getting tight, you may have been approved for a $50,000 line of credit, but because of the recession it may have been cut to only $20,000,” says Diane Masucci, a mortgage consultant and board member of the Financial Planning Association of New Jersey.
In addition, most HELOCs have variable interest rates. While some rates may offer lower monthly payments at first, those payments may go up during the rest of the repayment period. Make sure you understand the terms of either the home equity loan or home equity line of credit.
Once you’ve decided that taking out a home equity loan or line of credit is right for you, go to your credit union, bank or financial institution of choice and ask them about what home equity loan products they offer.
As part of the application process, your home and property will have to be appraised, and you will be subject to a credit check. While simpler than getting a mortgage, you will still be required to provide similar information to what a prospective homebuyer provides when seeking a loan, according to the Credit Union National Association. You’ll need to provide proof of income, as well as information about your credit and employment histories.
You’ll also need to be prepared for upfront and closing costs. Upfront costs typically include a property appraisal to estimate the value of your home and an application fee—which may not be refunded if you are turned down for the credit. Closing costs generally include fees for mortgage preparation and filing, taxes, and property and title insurance.
Nonetheless, when times are tight, either a home equity loan or a home equity line of credit could be a resource to help you finance major expenses, such as buying a new car, starting a small business, paying for a child's college tuition, paying off your own student loans or consolidating credit card bills.
But be careful. Don’t forget what’s at stake in not paying back the loan: The roof over your head.