For many people, a home is the most significant asset they own, and this asset can provide homeowners access to funding if they need it. But what is the best way to use your home as collateral?
The first thing to understand about home equity is the different ways you can use your home to deliver a cash injection – the two primary ones are a home equity line of credit (HELOC) and a home equity loan, which is often called a second mortgage.
What is equity in a home?
Home equity is the difference between the value of your home versus how much you owe on your mortgage. It’s important to understand your home equity as it will impact the amount of money you will be able to borrow.
What is a home equity line of credit (HELOC)?
As the name implies, a HELOC is a line of credit that a lender provides you based on the value of your home, the amount of equity you have in it and your credit qualifications. Like a credit card, you can use as much or as little of the money available in the HELOC, provided you make the minimum monthly payments on time. Some HELOCs even come with a linked debit card so it’s easier to make purchases.
Notably, however, most HELOCs have a variable interest rate. This means your rate, and therefore your minimum payment requirement, are subject to change, which can make it trickier to budget.
What is a home equity loan (sometimes known as a second mortgage)?
Unlike a HELOC, which allows you to draw out money as you need it, a second mortgage pays you one lump sum. You then make fixed-rate payments on that sum each month until it’s paid off. It essentially is the same as your first mortgage, only instead of using the loan proceeds to purchase a house, you get an influx of cash.
When to consider home equity financing
Typically, home equity lines and loans are used for home improvements such as a new roof, updated kitchen, refurnished basement and other projects of that nature. HELOCs give you flexibility to use as much or as little of the line of credit as needed while you improvements are in process. This flexibility lets you pay for materials and work as your project unfolds, whether you prefer weekend projects or longer-term renovations.
With property values up across the country, a home equity line or loan could be an excellent way to leave your existing first mortgage in place and still leverage your equity for home improvements.
Home equity loans are often used to pay off larger, more significant debts that you’ve already incurred. For example, if you have substantial credit card debt, taking out a second mortgage to pay off all outstanding balances could help, especially if you are able to secure a lower interest rate on your second mortgage repayments than you would with credit card repayments. Because the loan is secured by equity in your home, it’s often the lowest rate option for borrowing a fixed amount of money when a predictable monthly repayment amount is an important priority.
Some small business owners also take out second mortgages on their homes to keep their company afloat during challenging times.
What to consider and how to decide between a HELOC and a second mortgage
Neither a HELOC nor a second mortgage should be taken lightly. While they both provide an immediate cash infusion, they both also increase the amount of debt payments you’ll owe each month. There’s also a certain amount of risk involved because these loans are secured by your home. If you don’t make your HELOC or second mortgage payments on time and go into default, you could lose your home.
These options are not a one-size-fits-all approach and will vary based on your personal financial situation. First, determine what your overall goal is for financing and then decide what your risk tolerance is to make the most-informed decision.
If you are looking for ways to access cash, an alternate path to consider is belt-tightening. If you can, cut back on expenses and adjust your budget so you don’t necessarily have to take out a HELOC or second mortgage.
If you’re considering a HELOC or a second mortgage talk with a trusted financial partner. He or she can help you better understand your situation and decide which option is best, or if there’s a more strategic route to take.
HELOC vs home equity loan infographic
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