There are two main ways of releasing equity in your home: Home equity loans and Home equity lines of credit (HELOC). There are differences between the two, and one may suit you more than the other.
Most people see a release of equity in their homes as equivalent to a second mortgage. It's usually a larger sum of money than a personal loan and can be more flexible than other types of credit.
With a home equity loan you can borrow against your home’s value, which in turn allows a higher amount of credit than most personal loans.
There are two main types of loans that can address this issue. A home equity loan provides you with one large lump sum of cash with an interest rate attached to the whole amount.
A home equity line of credit, otherwise known as a HELOC, works more like a credit card, but with a high limit. You withdraw money against the value of your property as and when you need it, and only pay interest on the amount you've withdrawn.
You can find more information on individual lenders in our round-up of the best home equity loan lenders.
Home Equity Loans vs HELOC: How they work
To get started with a Home Equity Loan or HELOC, first work out how much money you have in home equity. This means finding your property's value and subtracting any money that you owe, i.e. a mortgage.
If you own your property in full then it's worth looking at the amount that lenders can provide, some may loan up to around 85%, but this does mean that your home is at risk if you default so it's a careful decision to make.
The amount lent tends to be made on your current loan-to-value ratio, this is the amount of debt that you still owe on the property. If for instance, you still have a large chunk of the mortgage to pay off, your loan-to-value ratio will be lower and so you would not be able to borrow as much.
Let's say your property is worth $100,000 and you owe it outright. You could get a home equity loan or HELOC up to $85,000. However, if you owe $50,000 on your mortgage then you will only be able to get half of that, or $42,500.
Home Equity Loans and HELOCs: What are they used for?
If you need to unlock a large sum of money in one go, then a home equity loan is ideal. After an initial phone call or application, you should agree with your lender just how much equity to approve and the interest rate and payment schedule to pay it back. Some companies will allow early repayments, so if you find yourself with more cash down the line you can pay the sum off quicker.
HELOCs often have an adjustable interest rate where you can draw the money as you need it and only pay interest on the amount you draw, just like a credit card. There is also the option to have an interest-only plan which can be helpful for bigger purchases, but must be paid back in full at a time agreed with your credit provider.
If you're not sure how much money you will need to borrow and when, but may need access to cash fast for items such as medical bills, then a home equity line of credit can be useful if the amounts are larger than a standard personal loan or credit card can offer.
Home Equity Loans vs HELOCs: Which is better?
Whether you are making small renovations to your home, your life circumstances have changed or you need additional money for whatever reason, then a HELOC could be a good idea. It allows you to spend when required and pay back over fixed terms, e.g. a monthly payment, or flexible terms, such as an interest-only arrangement. Because the amount you could be taking out is often lower than a home equity loan, the interest rate tends to start out lower too. Although the more you spend the higher this could rise.
This could give you a bit of breathing space if you believe repaying any debt could take some time, however, you should never take out debt if you do not believe that you will have the ability to pay it back. Your property could be at risk if you can't.
While interest-only might sound appealing if your finances aren't quite under control, you need to be aware this can be demanded after a fixed period, e.g. 10-years, so you will have to make sure that you plan for payment in full after the arranged time, or move on to a fixed arrangement to pay it back monthly.
Home Equity Loans, HELOCs and the IRS
There is also the question of whether or not a home equity loan is tax-deductible. The standard advice is to speak directly to the IRS but as a rule of thumb, homeowners may deduct interest paid on HELOC debt of up to $100,000. However, in some circumstances, this could be as low as $50,000.
The criteria have changed since the 2018 Tax Reform bill was signed into law. Interest on home equity loans and HELOCs are no longer tax deductible for any new loans unless you are using them for specific IRS-approved uses. These must be used to "buy, build or substantially improve the taxpayer's home that secures the loan".
Examples of what should qualify include:
- Building to expand your home
- Putting a new roof on the property
- Replacing your HVAC system
- Completing an extensive kitchen or bathroom remodelling project
- Resurfacing your driveway
Home Equity Loans vs HELOCs: Should you get one?
With a report by TransUnion estimating that HELOC originations are set to hit 11 million in the next five years, the good news is that all types of home equity loans should become easier to understand and apply for. The report goes on to estimate that new applications on HELOCs will double between 2018 and 2022, so it is in the interest of providers to offer a stress-free experience.
Essentially, if you need a large lump sum now or you need to be flexible with large amounts of cash over the next few years and you have a decent loan-to-equity amount, then both a home equity loan or HELOC could be right for you. However, as with any loan, whether you're arranging an interest-only loan or a fixed rate, it's worth making a full budget assessment to ensure you can pay back what is required.
