In many parts of the country, chances are you’ve recently gained some equity in your home. In some parts of the country, you might have gained a whole lot of equity (hello, west coast). But unfortunately, that equity is usually unavailable to you until you sell the home and cash in on it.
But what if you want to use some of that equity now? That’s where home equity loans and HELOCs (sometimes called second mortgages) can be really handy. These mortgages draw on the current equity you have in the home and give you cash now. No home selling required!
Are HELOCs and Home Equity Loans the same Thing?
You may hear the term home equity loan and HELOC used interchangeably, but they are different things. You’ll likely be more interested in one or the other depending on your situation and your financial goals.
It’s really important to compare the two carefully and understand exactly what you’re getting into. Tapping into your home’s equity can be a financially savvy move, but it can also be risky if you don’t take the time to understand what you’re doing and how it can affect your future finances.
To Determine Your Home’s Equity
Subtract what you still owe on your mortgage from the value of your home. This is the equity you have in your home, and it’s what can be used as the collateral for your new loan.
A HELOC, or home equity line of credit, is a lot like a credit card. Instead of borrowing a lump sum of money at one time, you are given a certain limit on the money you can borrow (this is often capped anywhere between 80 and 95% of the equity you have in your home).
For instance, you may be approved to borrow up to $50,000 of the equity you have in your home, but you don’t have to take that amount at once, or even necessarily take it all. You only borrow what you want to borrow and then pay interest on that amount only. You can draw money for as long as the draw period is, usually around 10 years.
At the beginning, HELOCs often have lower interest rates than home equity loans, but they also have an adjustable rate, meaning that your payments could rise or fall at any time. This can be difficult to budget for, especially if interest rates rise (which they have been doing lately).
Sometimes you can pay a fixed rate on a certain amount of money while paying a variable interest rate on the rest. And some HELOCs will allow you to pay only interest during the draw period, as well. But this means that you’ll pay more later since you’re not paying off any principal now.
A HELOC is great because you don’t pay interest on more money than you actually need. It allows you to tackle projects of all different lengths and costs, like buying a new refrigerator but then also remodeling a bathroom a year later. You only have to pay interest on the projects as you do them, so this is a good fit for expenses that come in stages.
It could also be a good fit for incremental expenses like college tuition.
It’s easy to overspend on a HELOC, especially if interest rate changes make your monthly payments higher than you’d anticipated.
Home Equity Loans
A home equity loan pays you a lump sum of cash. This sum is usually capped at around 80% of the equity you currently have in your home.
Home equity loans often have a fixed interest rate, which means that just like your primary mortgage, you’ll pay the same amount each month. Of course, this means that the loan is easier to factor into your budget because you know exactly what the cost of borrowing the money is each month. The payments will also last for a set period—usually anywhere between 5 and 20 years.
A home equity loan is great if you want to do a major, one-time renovation on your home. It’s also a good idea if you’re looking to consolidate high-interest debt all at one time.
If property values take a drastic decline in your area, you may find yourself upside down on your home (meaning that you owe more than it’s worth) for money that you’ve already spent. This situation can make it very tough to sell your home.
Things to Consider
Tapping into your home’s equity can be a fantastic way to accomplish some of your financial goals without selling your home, but it’s not a decision that should be taken lightly.
First, be aware that these second mortgages have closing costs and fees similar to those you paid with your primary mortgage.
Second, the risk when you use your home equity as collateral for your loans is that your home can be foreclosed on if you can’t make the payments. And, as I already mentioned, if the value of your home goes down, you could end up owing more to the bank than your home is worth.
To lessen the likelihood of these problems, some experts suggest only using your home’s equity if you’re going to use it to add value to your home. Other experts suggest using it only for major purchases that don’t depreciate quickly (in other words, using it for a car might not be the best choice).
As always, we encourage you to consult with a financial advisor if you have questions about your specific financial goals.
Tax Law Changes
Last, a quick note that recent changes to the tax law affect these loans, as well. From 2018 to 2026, borrowers can’t deduct the interest on these mortgage payments unless the funds are used to buy, build, or substantially improve the buyer’s home.
Deductions on interest are capped at $750,000 of loans per married couple or $375,000 of loans for a married taxpayer filing separately. (These amounts include the primary mortgage, as well.)
If you have any questions about how a getting a HELOC or home equity loan might help you take advantage of the equity you’ve built up in your home, give me a call! I’ll help you figure out what the best step for your unique situation is.