I’m not a big fan of debt.
But there are times in your life when it makes sense to pay off (or avoid) high-interest debt with low-interest debt. For example, using a 0% APR credit card with no balance transfer fee, in order to pay off a high-interest credit card can be a wise move, if executed properly.
Another example could be using your home equity to take out a low-interest home equity loan or a home equity line of credit, in order to pay off higher interest debt.
But before you run out to your bank, you must first understand the risk involved and the differences between the two.
Home Equity Loan (HEL)
A home equity loan, or HEL, is a second mortgage taken on a home, using your equity in the home as collateral. It usually comes in the form of one lump-sum payment in the beginning, with a fixed interest rate.
That doesn’t mean anything unless you know what home equity is, so we should probably cover that first.
Home equity is the market value of what you actually own in your home. It is calculated by taking the total market value of the home and subtracting any outstanding loans on the property. Take, for example, a home that has a current market value of $200,000 and you have a mortgage of $125,000 remaining. You would have home equity equaling $75,000 ($200,000 – $125,000).
Home Equity Line of Credit (HELOC)
A home equity line of credit, commonly referred to as a “HELOC”, is also a secured second mortgage, that taps in to the equity you have in a home.
The main difference between a HELOC vs. a home equity loan is that there is no lump-sum up-front payment, and funds that are borrowed as needed using a line of revolving credit, meaning that there is no fixed re-payment schedule or amount. You borrow what you need, when you need it, up to a specified credit line. You simply pay what you can (above and beyond minimum monthly payments), and your APR is based on the balance you owe. HELOC’s are much like credit cards in this respect, and are more flexible than HEL’s.
Another way they are like credit cards is in their calculated interest rate. They, most often, use a variable interest rate, taking whatever the prime rate is, and adding a margin to that. There are some HELOC’s that allow you to lock in your rate, however (a very valuable feature in periods of low interest rates, like right now, given how the prime rate cannot go any lower than it currently is).
HELOC’s generally have a lower APR than home equity loans because of the risk of interest rates increasing.
Benefits of HEL’s and HELOC’s
As mentioned in the beginning of the article, HEL’s and HELOC’s give you the opportunity to leverage your home equity to take out a loan with a low interest rate. In today’s borrowing climate, these rates are often lower than credit cards, consumer loans, auto loans, and even some student loans.
Interest on both HEL’s and HELOC’s can be tax deductible.
Risks of HEL’s and HELOC’s
Home equity loans and HELOC’s are both forms of secured debt against your home. The low interest rates you can get on HEL’s and HELOC’s are a result of them being secured against your home. If they are not paid off, you could be forced to foreclose on your home. As such, they should always be paid back in full.
Here’s the deal – both can be used strategically to pay off or avoid high interest debt. But they can also be grossly abused, if turned into a shopping spree or a justification to spend money on something you wouldn’t otherwise be spending it on.
Another risk with a HELOC is the potential for their interest rates to increase with adjustments to the prime rate. You could get stuck paying back your balance at high interest rates down the road, even if interest rates are low today.
Home Equity Loan Vs. HELOC
Here is a breakdown of the different aspects of each.
|Home Equity Loan (HEL)||Home Equity Line of Credit (HELOC)|
|Loan amount comes as:||1 lump-sum check when taking out the loan.||Funds are withdrawn as needed on revolving credit. Can be in the form of a check or debit card.|
|Debt is secured/unsecured:||Secured against your home.||Secured against your home.|
|Payment schedule:||Amortized. Specified amount over a specified number of months/years.||Minimum balance due monthly.|
|Interest rates:||Can be fixed or variable. Most often are fixed.||Mostly variable rate (prime rate + margin). Some come with rate lock option.|
|Fees/Costs:||Has closing costs.||Most do not have closing costs, but some have annual fees.|
|Taxes:||Interest can be tax deductible, but w/ the Tax Cuts and Jobs Act of 2017, the deduction for interest paid on home equity loans and lines of credit is only deductible, if used to buy, build or substantially improve the taxpayer’s home that secures the loan.||Interest can be tax deductible, but w/ the Tax Cuts and Jobs Act of 2017, the deduction for interest paid on home equity loans and lines of credit is only deductible, if used to buy, build or substantially improve the taxpayer’s home that secures the loan.|
HEL and HELOC Discussion:
- Have you ever taken out a home equity loan or home equity line of credit?
- What did you use it for? Was it a wise move or did it backfire?