The equity you have in your home can be one of the most important pieces of your retirement savings. Since it’s such a critical asset, borrowing against it should be considered carefully.
Taking out a home equity line of credit or a home equity loan can be a good way to access cheap credit or consolidate other debts, but it’s important to fully understand the associated costs and benefits. Both types of loans allow you to turn some of your home’s “equity” (the value of your home minus the amount you still owe on your mortgage) into cash. The less money you still owe the bank for your mortgage, the more equity you can turn into borrowable cash.
Many people take out home equity loans because the interest rates tend to be lower than for other forms of debt. However, home equity lines of credit and home equity loans differ sharply when it comes to interest rates and availability of credit.
Home equity line of credit (HELOC)
A home equity line of credit, or HELOC, functions like a credit card; meaning you can borrow when you want to, up to a defined limit. A HELOC also resembles a credit card in that the interest rate is “variable,” a term that should set off alarm bells when you’re considering a loan because it means your interest rate is subject to fluctuations and can suddenly increase.
A “variable” interest rate is one that fluctuates over time, unlike a “fixed” interest rate, which doesn’t fluctuate during the period of the loan. HELOC interest rates are considered to be variable and are usually determined by national financial “indicators” that have nothing to do with your financial history.
The most commonly used indicator is the “U.S. Prime Rate,” which is adjusted over time. The prime rate is used by lenders to assess how much they should charge borrowers and is not related to your credit history. Lenders will also generally add their own rate on top of this. The unpredictability of these interest rates can make it harder for you to establish a consistent repayment plan, especially if you’re on a fixed income because you can’t simply set aside the same portion of your income every month.
A situation when a HELOC might make sense is for a home renovation. That way, you only draw the money when you need it to pay for materials or labor and aren’t paying interest on the total amount of the renovation for the entire duration of the project.
Home equity loan
A home equity loan is a one-time, lump-sum loan of a specific amount of cash that is to be paid back over a set amount of time. Home equity loans generally carry a fixed interest rate, so you can expect to pay the same amount every month. Home equity loan interest rates depend on a combination of your credit score and the housing market in which you live.
Another important factor when considering a home equity loan is how it will affect your credit score. Credit agencies treat HELOCs like credit cards, so a high balance can negatively affect your score. Home equity loans, however, are treated as “installment loans” (the same type of debt as mortgages or student loans) and do not affect your score.
Before you enter into a loan agreement for either type of credit, consider how they will affect your broader financial picture.