Homeowners often turn to the equity in their home when they need a substantial amount of cash, whether it’s for home improvements or debt consolidation or maybe even a vacation.  Interest paid in home equity loans and lines of credit can often be tax-deductible, just like interest paid on a mortgage loan, so this is an attractive factor to many borrowers.  When looking into a second mortgage it is important to know the facts and chose the loan product, which is best suited to each individual’s needs.

A line of credit is very similar to a credit card or any other revolving credit account.  The borrower is given an available balance, which in the case of home equity lines of credit is comparable to or less than the available equity in the home. Equity refers to the amount of money a home is worth minus the amount owed on the home. For example, if a homeowner has $25,000 worth of equity in their home and needs to make home repairs in the amount of $12,000 they could conceivably request a line of credit in the entire amount of $25,000 and have the remaining $13,000 sitting in the line of credit, available for use.  As the borrower pays down the $12,000 they borrowed the amount of available credit goes up, and if the entire amount is paid off in many cases the whole $25,000 is again available, just like with the aforementioned credit card.  Some homeowners will open up equity lines of credit with a “just in case” mentality; they don’t have a specific need for the money but would like the have the available credit in case the need arises.

A home equity loan is similar to a home equity line of credit in the sense that the amount available for borrowing is based off the equity in the home.  This is not a revolving account, however, so as payments are made the funds do not become available again for use.  The money is paid in one lump sum instead of being readily available for whatever reason.  This is very similar to other types of loans like car loans and personal loans.  Like the equity line of credit, borrowers can generally only borrow amounts up to the equity available in their home.  Some lenders offer equity loans which exceed the available equity, but these sorts of loans are best avoided for obvious reasons; there is no guarantee that home values won’t depreciate, so borrowing more money than a home is worth can turn into a bad situation where borrowers can find themselves selling their home at a loss.

Which equity loan is best suited to what situation? It depends on what the funds will be used for. If a borrower is looking merely to have a credit line available in the event of an emergency then a credit line works well, but if a borrower has a one-time, specific monetary need with no additional anticipated need for funds then a loan is probably best.  If a borrower is going to have many home improvement projects going and isn’t sure of the total cost then a credit line works well; lenders will often issue checkbooks or credit cards on the credit line, making it easy to pay contractors without having to contact the lender each time for a withdrawal. 

Be careful when taking out a line of credit, though, especially of the amount you are loaned exceeds what you need.  As with any revolving credit, many borrowers may find the temptation too great and the money simply too accessible resulting in money being used for instances which borrowers did not originally plan on.  Credit lines are also usually variable rates whereas loans are fixed rates, so as rates go up the payments will too with a credit line. 

Home equity should be seen as more of a rainy day fund and less of a free money fund.  Use this resource only when necessary or you may find yourself with no equity in your home and a large bill due every month in addition to your mortgage.  Projects, which add to your home’s value, are good reasons to seek out an equity loan or line of credit, but a shopping spree is certainly not.

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3. Debt Handling: Home Equity Loans: Pros and Cons
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