Home Equity Line of Credit
A home equity line of credit is a variable-rate loan with a draw period and a repayment period. Home equity lines give you the flexibility to borrow additional funds up to your credit limit. Use your home equity line for whatever you need, whenever you need it. Accessing your funds is as easy as writing a check or using your debit card. You only pay interest on the money as it is borrowed. Once the money is paid back, you may use the funds again. The draw period is a timeframe (usually 5 to 10 years) in which you may borrow on the line and pay it back as many times as you like. You receive a bill each month based on your outstanding balance for either the interest only or for a combination of principal and interest. When the draw period is over, the full balance may be due or a repayment schedule may be set up, depending on your lender. Home equity lines of credit are a great tool when you are uncertain of how much borrowing you will need, or you anticipate having to borrow more funds in the future or for projects like remodeling, that have multiple payments phased in over time.
Home Equity Loan
Unlike a line of credit, a home equity loan is a one-time lump sum loan. It’s a good home equity choice if you know the full amount of money needed and you don’t anticipate having to borrow again in the future. You’ll receive the entire amount of the loan upfront and pay interest and principal on that amount right from the start. Home equity loans typically run anywhere from 5 to 30 years, and you make regular monthly payments until the loan is paid off. And unlike a line of credit, home equity loans can be fixed or adjustable rates.
Amortizing vs. Interest Only
There are two different methods that lenders use to determine your monthly payment on a home equity line or loan. The first type is referred to as “amortizing,” which simply means that you’re paying back both the interest and principal on your borrowings right from the start, even during the draw period. Almost all first mortgages and many home equity products today have amortizing payments. Amortizing loans are a more stable option because you’re paying both principal and interest throughout the entire life of your loan, making your monthly payment more consistent over time.
Interest only loans are exactly what they sound like. During the draw period, your monthly payment covers only the interest on your loan. Interest only loans have two phases: an interest only period and a repayment period. During the repayment period, your monthly payment includes both interest and the repayment of principal. This results in a lower monthly payment in the interest only phase and a higher payment in the repayment phase. Because you’re not paying back principal during this interest only phase, interest only loans don’t make progress towards paying back your loan or replenishing your equity and set you up for a much higher payment in the repayment period. Interest only loans were once quite popular. But because of their tendency to result in higher monthly payments after the draw period, they ended up being a leading cause of the 2008 mortgage crisis.
Determining How Much You Can Borrow
Most financial institutions will allow you to borrow up to 80% of the value of your home, less the balance of your first mortgage. Here’s an example of how to calculate how much you can borrow: