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Home Equity Lines of Credit
In simple terms, a home equity line of credit works a little like a credit card – a credit card secured by your home. Lenders approve you for a specific amount of credit, but you are not required to borrow up to the limit of your credit line.
How a Line of Credit Works
Here's an example. Say you are approved for a home equity line secured by the equity in your home. Most lenders will limit how much you can borrow, using a percentage of your home's value as a guideline.
In this example we will assume you have been approved for a $30,000 credit line.
You were also approved for a "draw period," or a time period within which you can access your credit line. Your draw period may or may not be renewable, depending on the terms of the financing. You make monthly payments on the amount you have drawn, and typically have a fixed number of years to pay back the outstanding balance after the draw period has ended. The primary difference between a home equity loan and a home equity line lies in how you access the money.
With a home equity loan, you receive the entire loan amount up front. If you borrow $30,000, you receive a check for $30,000 and you start making payments on the loan immediately. While some credit lines may require minimum withdrawal amounts, with a home equity line you choose when and how much money to draw from your home equity line of credit. If you are adding on to your home, you might decide to draw $10,000 the first month and wait several months before withdrawing additional funds to purchase building supplies, pay contractors, etc. Doing so lets you avoid paying interest on the funds you have not withdrawn. Then, as you pay down the principal balance on the home equity line, you can borrow against those funds again and again up until the draw period closes.
Once approved, you can borrow up to your maximum credit limit at any time. Most credit lines let you access funds using checks, ATM withdrawals, or a credit card tied specifically to your credit line, but keep in mind some credit lines require you to make a minimum withdrawal amount (typically less than $500). Or your credit line may require a minimum amount of outstanding balance, as well as an initial withdrawal once the account is set up and active.
In short, think of a home equity line as "just in time," renewable borrowing. Home equity loans are one-time, non-renewable loans.
Here is a quick breakdown of the differences between home equity loans and home equity lines of credit:
Home equity lines of credit generally use variable interest rates instead of fixed interest rates. The rate varies based on a common index like the prime rate or Treasury bill rate. Typically, the interest rate is calculated by adding an amount to the index; for example, your interest may be calculated using "prime rate plus 2%." In that example, if the prime rate is 3%, your interest rate will be 5%. The rate will change based on pre-determined time periods, typically at no more than one-year intervals, but sometimes as frequently as on a monthly basis.
By law, variable rate loans secured by your home must have a cap on how much the interest rate can increase over the life of the line of credit. In some cases, the payment amount may be capped as well.
Some credit lines contain provisions allowing you to convert from a variable interest rate to a fixed rate during the life of the plan, or let you convert all or a portion of a home equity credit line to a fixed-rate, fixed-term home equity loan.
Which is Right for You: Loan or Line?
Home Equity Loan
Home Equity Line of Credit
Need a simple way to decide between a home equity loan and a home equity line of credit?
If you need a lump sum at one time and want the stability of a fixed interest rate and fixed monthly payments, choose a home equity loan.
If you want greater flexibility and the ability to choose when and how much you will borrow and are willing to accept the potential for changing interest rates and payment amounts, choose a home equity line of credit.
Talk to your lender about whether a home equity loan or a home equity line of credit is the best choice for your individual needs and goals.