Home Equity Vs. Line of Credit

There are many similarities between a home equity loan and a home equity line of credit (HELOC) – and, at least, one primary difference. When you consider a HELOC versus a home equity loan, your reason for borrowing may dictate which one is right for you. If you get a home equity loan, you will receive your entire loan amount right after closing. With a home equity line, you will normally receive no money after closing. Unless you need an immediate disbursement, your HELOC lender will set up your home equity line of credit loan and you can then “draw” on it whenever you choose.

You’ll often see another difference that usually involves a home equity versus HELOC monthly payment structure. For instance, if you have a fixed rate home equity loan, your monthly payment will be set and maintained over the term of your loan. Whether you get a fixed rate, adjustable rate, or interest-only home equity line, your HELOC payment will vary month to month depending on the outstanding balance of your loan. Home equity line rates will be close to home equity loan rates but the monthly payment can be quite different as a function of your balance.

The remaining components of home equity loan information, qualification, other loan terms, reasons for borrowing, and legal issues (title examination, mortgage recording, etc.) are identical with both loans. If you need the entire balance of your new equity loan from the beginning for a specific purpose, a home equity loan will be a good choice. Should you not be sure when you’ll need some or all of your cash out amount, a HELOC loan might be best and save you interest costs, too.

The first common question: What is home equity? The difference between your home’s Fair Market Value (FMV) and the balance of your first mortgage is your home equity. If you sold your home today, this is the amount of the cash you should receive. This value will also be the basis for a home equity loan.

This leads to the next question: What is a HELOC? HELOC is the common acronym for home equity line of credit. Home equity credit lines are very helpful to homeowners since they can use their funds how and when they want, simply by writing a check or requesting a disbursement from their lender. They don’t have to increase their loan balance until they want to do so. In addition, there is no interest cost on available funds not used so a HELOC home equity can often save you money.

Unlike a home equity loan, the full balance of which is disbursed at closing, a HELOC is set up to allow you to use a part or all of your available loan funds when you want them. If you prefer to keep your available funds in “reserve” for emergencies, you can do it. No loan interest is due on unused line of credit funds. Should you need some or all of your available funds right away, once again you can do so. Do your homework and learn about HELOC’s and how they operate. You will find the best program for you.

The way interest is calculated appears to be different with a home equity line of credit (HELOC) versus a home equity loan because repayment terms often differ with each loan type.

Home equity loan interest charges are calculated much like a first mortgage loan. You borrow an amount of money, the proceeds are disbursed to you (or your designee), and one month later, you begin repaying at a pre-calculated monthly payment. If you have a fixed rate, your monthly payment will remain the same over the term of the loan. Even if you have an adjustable rate loan, your payment will remain consistent until the rate changes, after which a new regular monthly payment will be due until the next adjustment date.

A HELOC, whether a no doc or stated income HELOC, or a full doc loan, works differently and interest is applied somewhat differently, too. In fact, many HELOC’s require interest-only monthly payments with no principal payback necessary. This process will usually also be applied to a mobile home equity loan, if you are fortunate to locate one.

Here is an example which should help explain the process better:

You are approved for a HELOC of $50,000 at 8% interest for 15 years.

Month 1:
Balance ............. $0
Monthly Payment Due $0

Month 2:
Advance ............ $4,000
New Balance ..............$4,000
Payment Due (Interest) $26.6

Month 3:
Balance ............ $4,000
Advance ..................... $2,000
New Balance ............. $6,000
Payment Due (Interest) $40.00

Month 4:
Balance ............$6,000
Principal Payment .....( $1,000)
New Balance .............$5,000
Payment Due (Interest) $33.33

As your balance fluctuates as you take and use available funds and/or pay back some principal, your monthly obligation to your lender varies. In essence, your monthly payment is recalculated every 30 days depending on the activity in your HELOC account. You have the ability, within your loan terms, to control your monthly payment. The actual interest rate calculation is the same for both loan types, but the resulting monthly payment requirements are often very different.

Using a home equity loan or a home equity line of credit (HELOC) may be better than using a first mortgage refinance in some circumstances. From a pure “cash flow” point of view, refinancing your first mortgage, assuming the term is 30 years, will result in a lower monthly payment in almost all cases. Therefore, if cash flow is your overriding concern, a first mortgage refinance will probably be your best choice.

However, there are many good reasons to use a home equity loan or HELOC instead of a first mortgage refinance. The following are some scenarios that indicate using a home equity loan.

• First mortgage interest rates have risen since you obtained yours, which is now at a “bargain” rate. It makes little sense to give away a below-market interest rate, which is applied to a large amount of borrowed funds, to borrow a smaller amount of money.
• You need a specific amount of money for home improvements, debt consolidation, delinquent tax payments, etc., and you do not want to pay interest on this amount for 30 years. You can probably pay back this loan over 5, 10, or 15 years and save thousands of dollars of interest payments.
• You have a reasonable first mortgage loan but your employment situation has changed. You have found a stated income HELOC, which you now need, and can get the funds you want without affecting your first mortgage.
• You want access to low cost funds but are unsure how much you’ll need and when you might need them. A HELOC would be much better than a first mortgage refinance in this situation.

The repayment terms are usually different with a home equity line of credit loan (HELOC) versus a straight home equity loan because you don't know how much you'll be taking out from month to month. While the home equity definition applies to both products, they operate quite differently. This difference in operation is the reason that repayment terms also take divergent routes.

Home equity loans are disbursed (proceeds given to you or a third party) in full right after closing of the financing. Should your loan be at a fixed rate, you can calculate your payment in advance and know it will remain the same for the term of the loan. Your lender will do the same so you will know your monthly payment obligation prior to closing. Even an adjustable rate home equity loan will require the same payment unless and until your interest rate adjusts.

HELOC repayment terms must, by definition, be calculated differently. If you get a $50,000 HELOC, it would be impossible to calculate a monthly payment in advance. Even if you opt for a fixed rate HELOC, a regular monthly payment cannot be estimated before closing since neither you nor your lender knows what your outstanding balance will be from month to month. You, not your lender, will determine your loan balance, since you can access your loan funds as you wish, and you will also consequently determine your monthly payment depending on your balance and interest rate since your outstanding loan will fluctuate based on additions to and monthly repayments of your balance. Even a home equity line of credit calculator will only be able to project your payment one month at a time.

What is home equity line of credit and how should I use it? A line of credit based on the equity in your home can be a wonderful way to have access to low cost borrowed funds to improve your financial health. Like a credit card without the high interest rates, a HELOC provides you with access to substantial cash when you need it. Some of the best ways to use a HELOC include –

• Home improvements – as work is completed, you can use your line-of-credit funds to pay for materials and labor;
• Debt consolidation – as needed, you can access funds to pay off high interest unsecured loans and credit cards;
• Down payment on additional real estate purchases – use available line-of-credit funds for a low cost down payment on another property; and
• Unexpected needs and emergencies – a wonderful, low cost form of “insurance” to have funds available when you need them.