Home Equity Loan vs. Home Equity Line of Credit

One of the most important decisions that have to be made regarding your second mortgage is that of a home equity loan vs. home equity line of credit. We’ll explain the differences between each loan type as well as their pros and cons.

Home Equity Loans
A home equity loan is just like any other second mortgage. A home equity loan allows you to borrow money against your home equity, and pay it off over time. Home equity loans differ from lines of credit in that the loan is paid off over time; home equity loans are amortizing loans.

In general, a home equity loan may be fixed or variable interest rate, though many borrowers choose fixed rate loans when possible. In a fixed rate loan, the interest rate is fixed from the day of issuance to the day the loan is paid off, which means there won’t be any surprises in your monthly payment.

Borrowers also have a choice to decide on an amortization schedule for a home equity loan. Typically borrowers choose to apply for a home equity loan with a 5-15 year amortization, meaning that the loan is paid in full after 5 to 15 years, or the duration of your choosing. While a 5 year loan will have higher monthly payments than a 15 year loan, the 5 year loan will also cost less in interest. Plus, a 5 year loan will come with a lower interest rate than a 15 year loan. This difference is often 1% or more, an amount that can add up to thousands of dollars over the life of the loan.

The only downside to a home equity loan is that once approved you usually cannot borrow more money until the loan is paid in full. Also, the monthly payments are fixed, and you must at least make the minimum payment each month even if you don’t prepay the loan. Making the minimum payment will ensure that the loan amortizes over time and is paid off just as it needs to be.

Home Equity Lines of Credit
A home equity line of credit varies significantly from a home equity loan. First and foremost, a line of credit is a loan which is open-ended. Thus, a borrower may borrow more money on the same line of credit at any time, and also pay down the loan at any time. Think of a home equity line of credit like a really big credit card without the sky-high interest rates. You can pay the balance down, or spend more on it. But either way, the choice is yours at any time. This is very different from a home equity loan, where the amount of borrowing is set from the first day.

Secondly, home equity lines of credit differ in that they have a variable interest rate. Fixed interest rates are not available on home equity lines because the interest rate could easily change from the date of issue to when they’re paid off. Having fixed rate home equity lines of credit would risk the possibility that the bank would have to borrow money itself at…say 5% to lend to you at 4%, a money losing proposition for the bank.

Finally, a home equity line of credit has a very long amortization period, if any at all. Many home equity lines of credit allow you to borrow on the basis that the line is interest only, meaning that minimum payments do not do anything to reduce the principal. If you were to borrow $10,000 at 10% interest, your minimum monthly payment might be little more than $83.33 per month, an amount that only pays for the $1,000 in annual interest charges.

Benefits for both
There are benefits to both types of loans that you simply will not find in any other kind of consumer finance. First, home equity loans have the lowest rates of any loan because the loan is secured by your home equity. That means that the bank has a right to take your home if you don’t pay, which can be a borrower’s liability more than the low interest benefit. Keep this in mind before you borrow, but know that this policy does keep rates lower than normal.

Finally, all home mortgage interest is tax deductible. If you’re in a high tax bracket and reach the annual standard deduction, a home equity line of credit or loan’s interest expense can be deducted after income. For those in a 20% tax bracket, the deduction would reduce a 5% interest rate into an effective rate of 4%, a very considerable cost savings.