Owners of real estate, including home owners, are able to access the equity in their property in several ways, including reverse mortgages, liquidation of the underlying real asset, and using the property as collateral for a loan. A home equity line of credit or loan is a way to use the equity in a piece of real estate as collateral for a loan or line of credit. The loan or line of credit places a lien on the real estate that is used as collateral, which has the effect of reducing the amount of equity in the real property. Here we will discuss the situation where a homeowner uses their primary residence as the collateral for this credit. In this scenario, the interest on the loan or line of credit is typically tax deductible.
Home equity loan versus line of credit
A home equity line of credit (frequently known as “HELOC”) is a facility which can be accessed or drawn upon by the borrower. Funds can be drawn during the draw period, and the payment amount during the draw period is usually based upon the amount drawn and the interest rate on the loan. Oftentimes it is only required to make interest payments during this period, and in some situations no payment is required. The length and terms of the draw period vary. Once the draw period ends, the repayment period usually begins, and the required payments during the repayment period are typically higher than during the draw period. In some cases, a single lump sum payment, known as a “balloon payment”, is due at the end of the draw period, which can expose the borrower to significant risk. Interest rates on a HELOC are usually variable.
A home equity loan is a lump sum loan amount, secured by the equity in the home, which must be paid according to a fixed term or schedule. Unlike with a HELOC, which usually has a variable interest rate, the interest rate on a home equity loan is typically fixed.
Any home equity loan or line of credit contract or agreement should be understood carefully and in detail before executing or signing. Careful attention should be paid to interest rates and repayment periods and terms. Keep in mind that you typically have the right to cancel any home equity loan or line of credit contract within three days of signing.