Consumer Credit
What is the difference between a home equity loan and a home equity line of credit?
Vicki A Benge
The simple difference between a home equity loan and a home equity line of credit is that the loan is essentially a second mortgage and the line of credit is similar to a credit card or checking account with a home's equity as collateral for the guarantee that the homeowner will repay the loan.After a homeowner has paid on their home for a number of years, they build up what is called equity. This means that the home's value is more than is owed on the remaining mortgage balance. Most financial institutions are willing to loan up to 80% of the appraised value of a home, minus what is owed on the mortgage. For instance, if a home appraises for $100,000 and $30,000 remains on the mortgage, the homeowner has equity of $70,000. Thus, a financial institution would likely loan $50,000. This is calculated by taking the $80,000 (80% of the appraised value) and subtracting the $30,000 owed, which equals $50,000.
If a homeowner has built up equity in a home and is thinking of using it to consolidate debts, make home improvements, or even take that dream vacation, there are two ways the homeowner can utilize the equity.
The first way is through a home equity loan, which as stated above is basically a second mortgage. Home equity loans are generally received in a lump sum in one payment. The homeowner will usually be expected to pay the agreed upon interest plus other closing fees. This type of loan is sometimes convenient to consolidate debts that are at a higher interest rate than what is offered on home equity loans.
These types of loans are also used to pay for education, weddings, and other items that might provide the homeowner with a tax deduction. Home equity loans generally require set monthly payments just as a first mortgage, though the interest rate and payment may fluctuate with a base index interest rate.
The second way to borrow against equity is by obtaining a home equity line of credit which works very similar to a credit card. The homeowner is granted a "limit" which is usually the amount of equity in the home. Once approved the homeowner may borrow any amount at any time up to the pre-set limit. For example, if the financial institution agrees to a line of credit of $40,000, that means the homeowner can borrow up to $40,000 in one large sum, or in a number of smaller sums. As long as the homeowner remains within the limits of the equity line of credit, he or she does not have to re-apply for a loan each time funds are needed.
A home equity line of credit may be needed to finance home improvements or for other projects where small increments of capital are needed over time. Though it is not always the case, in normal market conditions a home equity line of credit carries a slightly higher interest rate than a home equity loan.
Although there are differences between a home equity loan and a line of credit, both are secured by the same collateral, the borrower’s home. Therefore, both forms of debt are a serious responsibility.
