When you own a home, and pay down the mortgage on it, you're building equity. You can tap this equity to fund home repairs, pay down high-interest-rate credit card debt, help finance your children's college education or take a cruise around the globe. To do this, you'll need to take out either a home equity loan or home equity line of credit. There are important differences between the two, the main one being that a home equity line of credit acts more like a credit card with your home as collateral while a home equity loan is actually a second mortgage loan on your home.
Your home's equity is the difference between what it is worth and what you owe on your mortgage loan. If you owe $200,000 on your mortgage loan and your home is worth $250,000, you have $50,000 worth of equity. When you are taking out a home equity loan or home equity line of credit, you'll be able to borrow a portion of this equity. A lender, for instance, might allow you to take out a loan or line of credit for as much as $40,000 of your $50,000 worth of equity.
Home Equity Loan
A home equity loan is exactly what it sounds like, a second mortgage loan on your home. When you take out a home equity loan, your lender will provide you with a lump sum payment. You then have to pay that money back, with interest, in monthly payments, much like you already do with your first mortgage loan. You are free to use the money from a home equity loan for any purpose.
Home Equity Line of Credit
You can borrow against your home's equity without taking out a second mortgage loan. You do this with a home equity line of credit. Your lender will provide you with a line of credit with a maximum balance that depends on your home's equity. If you have $40,000 worth of equity, your lender might provide you with a line of credit with a maximum balance of $30,000. You can then borrow from this line of credit whenever you like. If you want to fund $10,000 worth of home repairs, you can borrow the $10,000 from your line of credit. This would leave you with $20,000 that you can still borrow. Much like with a credit card, you only have to pay back the amount that you've borrowed, plus interest. You won't have to make any payments on a line of credit if you don't have a balance on it.
Which is Best?
You'll have to consider your own financial situation to determine whether a home equity loan or home equity line of credit is best for you. In general, though, a home equity loan makes sense when you need money for one large expense and you know how much you need. For instance, you might need $20,000 to pay for a kitchen renovation. This is a one-time expense with a set budget. But if you need money on a continual basis -- maybe to pay for your daughter's college tuition every year for four years -- a home equity line of credit might be the better choice.