Loan versus line of credit
There are two types of home equity loans. A standard home equity loan is a lump-sum loan that offers fixed payments over a set period of time, typically from five to 15 years. The loan is usually for a specific purpose, such as buying a car or paying off debts, and the check(s) may be paid directly by your lending institution. This is a one-time loan, after which you make the fixed monthly payments for the specified term. It is usually the best option if you need a given amount all at once, such as a home improvement or a new car.
A home equity line of credit (HELOC) is a specified maximum line of credit that allows you to borrow whatever and whenever you want, up to the maximum amount of your line of credit. Basically it's like having a credit card. You can borrow the entire amount at once, or you can borrow smaller amounts whenever you want, as long as you don't exceed the maximum amount of the line of credit. As you pay back the loan, your credit limit is restored accordingly. For example, you might arrange for a $50,000 line of credit and then write checks for $10,000, $5,000, and $5,000 over the next six months. You will pay interest only on what you borrow, so if you don't borrow you won't owe anything. A line of credit is the way to go for people who will be borrowing irregular amounts to pay college tuition or help support a new business.
Generally, the loan period for a HELOC is divided into two segments -- a "draw" period and a "payback" period. During the draw period, typically five years or so, you can borrow at will. The length of the draw period is set out in your contract, along with minimum withdrawal amounts and any restrictions on how often you can tap the credit line. The payback period will be used to repay the outstanding balance, and will usually have a term of five to 10 years.
How much credit can you get?
Your home equity is the difference between what your house is worth and the amount you owe on it. For example, if your house is appraised for $200,000 and the balance on your mortgage is $100,000, then your equity is $100,000.
The lending market has gotten so competitive that you could borrow up to and beyond 100% of home equity. It all depends on the lender's loan-to-value (LTV) ratio, your credit history and the interest rate you're willing to pay. Generally, the higher the LTV ratio, the higher the interest rate you will be charged.
Determining your limit is not as easy as you might think. If a lender uses an 80% LTV ratio, for example, you could borrow up to 80% of the appraised value of your home. For the $200,000 appraised value, you could borrow $160,000 minus your existing mortgage of $100,000, which equals $60,000 with an 80% LTV ratio.
HELOCs usually carry a variable interest rate a few percentage points above the prime lending rate. This is considerably lower than what you'd probably pay on a credit card or unsecured loan, but potentially much higher than the standard home equity loan with a fixed rate. Since the HELOC is a variable rate, it can rise quite a bit over the term of the loan.
How much of the interest is tax deductible?
If the money is used to improve your home, there is almost no limit. You can deduct up to a total of $1 million of mortgage loans used to buy a home or make major improvements. For other home-equity debt, the cap is $100,000 (beyond the loan you took to buy the house). The interest is deductible for any use except buying tax-exempt bonds or single-premium life insurance.
As an example, assume that you took out a $10,000, ten-year home equity loan at 8%. In the first 12 monthly payments, interest totals $775. If you are in the 27% tax bracket, the federal tax benefit will be $209 of the interest. In this case, you really paid a little more than 6% on the loan because of the tax benefit.