A home is often the biggest asset that any person will ever own, which means that over time it can be a valuable way to generate money that you need by using the home as collateral for things like home equity lines of credit (HELOC) or home equity loans. However, since these represent taking on additional debt beyond your initial mortgage, it’s important that you understand what they are and how to use them wisely to avoid getting into too much debt.
Defining the Terms
Before we talk any more about HELOCs and loans, let’s quickly define the meaning of several terms you will see in this article.
- Collateral is a tangible object or property that you put up as a guarantee in exchange for a loan. If you fail to repay the loan, the property will be taken to satisfy the debt.
- Equity is the difference in value between what your home is worth and what you currently owe on the mortgage.
There are two ways to gain equity in a home—the first is to pay off a portion of the principal balance that you own, the second is for the home to gain value. If you put a down payment on your home, you have instant equity in the amount of your down payment, and when you make your monthly payments you will be paying a portion toward the principal, which provides you with additional equity. Generally speaking, the market value of homes often increases over time, which means you are simultaneously gaining equity through that as well. Unfortunately, though, if market values for homes decline (as they did during the Great Recession that began around 2008), you can also lose equity.
Loans vs Lines of Credit
If you do have equity in your home there are two ways you can borrow against that equity to get cash: a home equity loan and a HELOC. Both are often called a “second mortgage” because you use your home as the collateral, although they may not have 30-year terms like your original mortgage.
A home equity loan is a single lump-sum amount that you pay off over a set amount of time. It has a fixed interest rate and the payments are set each month, much like a fixed rate mortgage. You cannot borrow additional money from a home equity loan. HELOCs, on the other hand, are more like credit cards with a revolving balance. You can get approved for a HELOC based on equity, borrow money against that line of credit, repay the money and borrow against it again in the future for the duration of the “draw period”, which is usually around 5 to 10 years.
Many homeowners like HELOCs because they offer more flexibility to borrow and repay as you need the money, rather than getting a single lump sum all at once. HELOCs do have variable interest rates, though, which means payments will be different depending on market rates and conditions.
In both cases you must repay the entire loan when you sell your home, so it’s best to keep an eye on the market value of your home and avoid borrowing more than you could repay if you were to sell.