The word “loan” can be an intimidating thing to hear at times. Thoughts of unmanageable debt and foreclosed homes may be some of the nightmares it can evoke, and if you remember its implication when the housing bubble popped in 2008, the very utterance of the word may leave a dirty taste in your mouth.
However, when used responsibly, Home Equity Loans and Home Equity Lines of Credit (HELOCs) are both advantageous ways to increase your spending capabilities. Home Equity Loans and HELOCs are two types of second mortgages that use the equity in your home as collateral.
The amount of equity in your home is based on the value of your home minus what you owe. So, if your home is worth $250,000 and you have paid $100,000 on your home mortgage, you have $100,000 in equity. If the value of your home increases so will your equity, regardless of how much you have paid on your mortgage.
With a Home Equity Loan, you receive one lump sum of cash, which you are required to pay off gradually at a fixed interest rate. With a HELOC, the interest rate is not fixed and may change based on the market.
A HELOC gives you a limited line of credit from which you can pull money as you need it. It essentially functions like a credit card but with your home as collateral. Due to its variable rates, a HELOC may have a lower interest rate when you first apply for it. Conversely, a Home Equity Loan may initially have a higher interest rate. However, if interest rates go up, the fixed rate of a Home Equity Loan could save you more money than a HELOC in the long run.
So, what are some prudent reasons for taking out a second mortgage? On the conservative end of the spectrum, some advisors say you should only use a second mortgage for emergencies and essentials, such as critical home repairs or medical bills.
A more moderate approach would be to use your loan for less urgent home renovations, debt consolidations, and education expenses. Be sure to consult a financial advisor if you need guidance that is specific to your situation, or if you are unsure about the risks.