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Home Equity Line of Credit 101

If you're interested in a HELOC or home equity loan, you need to consider the following things...

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Understand the difference.

If you own a home, you're familiar with the home equity line of credit (often called a HELOC). But maybe you have some questions – you don't understand the difference between a HELOC and a home equity loan, or you don't know how to get your hands on either. Consider this your crash course.

First, let's tackle the difference between these two products, starting with how they're similar: Both are secured loans, which means you're putting up your home as collateral for the money you borrow. Both offer fairly low interest rates, particularly right now, and allow for a tax deduction. And both require equity in your home. Essentially, these products are second mortgages: You're borrowing the equity in your home to use the cash.

The difference is that with a home equity loan, you receive a lump sum and pay it off on a monthly basis over a set period of time, generally between five and 15 years, although lenders may offer terms as long as 30 years. The interest rate and monthly payment will be fixed for the life of the loan. You may want a home equity loan if you need a large chunk of money at once – to consolidate credit card debt (only a good idea if you trust yourself not to run the cards back up once you've cleared the debt off of them) or make home improvements, which is the original purpose of this kind of loan.

A HELOC is a little more complicated. It's a pot of available money that you can draw on as you need it. Sort of like a checking account or, more accurately, a credit card, because you pay interest on the money you borrow. You'll be given a debit card or check book to access the money, and a maximum amount you can borrow, but you don't have to use it all, and you won't pay interest on the portion you don't tap. The interest rate on a HELOC is generally variable, which means your monthly payment will vary as well. If you want some money in your bank pocket in case you ever need it – sort of like an extra emergency fund – you may be a good candidate for a HELOC. They also tend to be good for someone who has an ongoing home improvement that he'll want to borrow for in increments over an extended period of time.

If you're interested in a HELOC or home equity loan, you need to consider the following things:

  • Your credit score. If your score is low enough (minimum requirements vary by lender, but under 620 would have me very worried), you may not qualify for a loan at all. But credit scores don't weigh as heavily with home equity loans and lines of credit because you're putting up the home as collateral. Still, a low credit score will get you a higher interest rate. Fair Isaac and Company (the company behind the FICO score) provides a continuously updated chart on its website, showing the difference in interest rate by credit score for a 15-year, $25,000 home equity loan. They say a score between 740 and 850 will get you an APR of 7.013% right now, while a score between 640 and 669 will get a rate of 10.088%. (Right now, rates are lower on HELOCs than home equity loans – a $30,000 HELOC is averaging 4.64% right now; the same amount in a home equity loan is 6.00%.) The takeaway here is that it pays to bring your credit score up before you apply.
  • Whether you have enough equity. Most lenders will lend you up to 75% or 80% of your home's current market value, minus the amount you owe on your mortgage. So let's say your home is worth $250,000, and the balance on your mortgage is $100,000. That means a lender may offer you up to $100,000 in a home equity loan or HELOC. If, on the other hand, your mortgage balance was $200,000, you'd likely qualify for nothing.
  • The cost. You'll pay less than you paid in closing costs for your mortgage, but you still may have to cough over some money. First, for an appraisal to determine your home's current market value. Then, almost all lenders will charge closing costs for a home equity loan (some may not for a HELOC). They'll be rolled into the amount of the loan, and may add up to 1 to 3% of the total borrowed. Make sure you know what you're paying for and you shop around for the cheapest lender and the best interest rate.
  • The tax perk. If you itemize your taxes, you may be able to deduct the interest paid on a home equity loan or HELOC if the loan amount is limited to $100,000. It doesn't matter what you used the money for.
  • The fine print. HELOCs may have a minimum withdrawal amount, requiring you borrow at least a certain amount each year. Consider this when shopping for a lender, and make sure you find one that has a low minimum amount if you don't think you'll need to borrow much money or you are using this line of credit as a backup emergency fund. Also, the bank has the ability to freeze or cut off your HELOC, something we saw happening a lot during the financial crisis. It's just like a credit card company lowering your credit limit. If this happens, you'll receive a letter from the lender letting you know why.
  • The other downside. Again, you're putting your home up as collateral. That means you don't need a down payment for a home equity loan or line of credit, but it also means that the lender could take your home if you don't make the payments on the loan.

Article was written by Jean Chatzky, personal finance expert, best-selling author, and Editor In Chief at SavvyMoney and provided by SavvyMoney®