You need to borrow money to pay for your children's college education. Alternatively, maybe you want to pay down your high-interest credit card debt or add a master bedroom addition to the top floor of your home.
One way to do so is to tap into the equity you've built up in your home.
Building up equity is one of the most important benefits of owning a home. As you pay off your mortgage, you gradually build equity. Simply put, equity is the amount of your home that you actually own. For example, if you have a house worth $200,000 and you owe $150,000 on your mortgage, you have equity of $50,000.
You can access that equity in one of two ways, through a home equity loan or a home equity line of credit.
Home equity loan
A home equity loan is a second mortgage. When you apply for a home equity loan, you'll receive a single lump sum. You then pay that sum back over a set period of years. The size of your home equity loan will be limited, of course, by the amount of equity you have in your home.
The interest rate attached to a home equity loan remains constant throughout the life of the loan.
Home equity line of credit
Consumers often confuse home equity lines of credit -- better known as HELOCs -- with home equity loans. However, a HELOC works more like a credit card than a mortgage loan.
With a HELOC, you'll receive a set credit limit. You only pay back the amount of money that you borrow, plus interest. For instance, if you have a HELOC with a credit limit of $50,000 and you borrow $10,000 from it, you'll only have to pay back that $10,000. You'll still have $40,000 worth of credit available to you after you've borrowed the $10,000.
The interest rate on a HELOC is usually tied to the prime rate. Often, the rate will be 1 percent over prime.
Which is better?
So, which product is better? Not surprisingly, that depends on the individual borrower and the individual situation.
Many economists say that a home equity loan is better suited to borrowers who need funds for a specific purchase, such as college tuition or a major kitchen remodel. Since a home equity loan features a fixed interest rate, such a product might be better for those borrowers uncomfortable with uncertainty.
A home equity line of credit, though, provides more flexibility. Homeowners do not have to tap into their credit unless they need it. Because of this, many homeowners use a HELOC as an emergency fund, quick cash in the case of an emergency. A HELOC might be the right choice, too, for borrowers taking on a multi-year renovation project. These borrowers can then tap their HELOC whenever they need to write a check to move the project toward completion.
The key is to do your research before choosing either a HELOC or home equity loan. Only by studying your spending habits and needs will you be able to make the right equity decision.