There are a handful of different ways homeowners may owe money on their home. There are mortgages, Home Equity Lines of Credit (HELOCs), and home equity loans. Since we’ve already written extensively about mortgages (see other blogs: overview, conventional, FHA, VA, and ARMs), let’s go over the differences between a HELOC (pronounced HE-lock) and a home equity loan. These are sometimes referred to as “second mortgages.”
Equity is the difference between what an asset is worth, and the amount owed on the asset. Thus, when a buyer borrows money to purchase a home (asset) at market value, the down payment is the homeowner’s equity because the down payment is the difference between what the home is worth and the loan balance. Over time, the home generally will increase in value and the homeowner will be paying down their loan. In this way, the difference between the value of the home and the mortgage balance grows, and that amount is the homeowner’s equity.
For example, Andrew buys a home for $200,000, and he puts 10% down. This means that Andrew’s loan amount is 90% of the purchase price ($180,000), and his down payment is $20,000. Remember, initially the down payment is also the amount of the equity. If we assume Andrew’s interest rate is 4%, after 5 years his loan balance will be approximately $160,000. If the house goes up 4% in value each year, it will be worth about $240,000. Andrew’s equity will have gone from $20,000 to $80,000 in 5 years.
Both HELOCs and home equity loans allow homeowners to tap into the increased equity in their homes. Home equity loans offer homeowners a lump sum of cash. They have closing costs, just like a mortgage. HELOCs, on the other hand, are lines of credit. Rather than the bank providing a large sum, homeowners have access to this sum over a period and they can use what they need, and only pay interest on the amount they use. Home equity loans are great if there is a specific home renovation or other expense (like a wedding) the homeowner needs to pay for. Home equity lines of credit are good in case of an emergency or if there are varying amounts of cash needed over time.
With either a HELOC or a home equity line of credit, the home is used as collateral. It is a tempting idea to access the home’s equity, however, these need to be paid back. If the homeowner finds they cannot make the payments, they will lose their home.
In either case, lenders typically allow borrowers to finance 80% of the home’s value in total. Keeping with Andrew’s example above, if he wanted to take out a home equity loan in 5 years, his loans on the home would be permitted to total 80% of the $240,000 value, which is $192,000. Since he would already owe $160,000, he could get a home equity loan for $32,000.
HELOCs and home equity loans are powerful financial tools when used responsibly, like to renovate a home. If used irresponsibly to buy unnecessary items, borrowers put their house on the line as collateral for things they do not need. (For information on using home equity to consolidate debt, check out this article on Info For Investors.)
Many people use the terms “HELOC” and “home equity loan” interchangeably. At Adulting Is Easy, we’re fans of using proper terminology whenever possible and the key to remembering the main difference between these loans is in the name. One is a line of credit and one is a lump sum loan.