Home Equity Loans vs. Line of Credit

So if you have a HELOC, you simply write a check or draw down on your home equity using a credit card issued by your mortgage lender.

You also pay back a HELOC differently. With a HELOC, there are two phases: a draw period and then a repayment period.

If you secure a home equity line of credit on Feb. 1, 2015, and you have a 10-year draw period, you'll be able to borrow from the credit line until 2025.

After Feb. 1, 2025, your repayment period begins and you're no longer able to borrow funds. During the repayment term, which can be anywhere from five to 20 years, you'll repay your lender the principal amount still outstanding as well as interest on the remaining funds borrowed.

Because of how HELOCs are structured, they can provide much more borrowing flexibility than home equity loans, some experts say.

At Citibank, for instance, borrowers can access line of credit funds for five years (the draw period) and then they have a 20-year loan repayment term.

"One advantage of the HELOC is that, just like with a credit card, you're only paying interest on what you've used," says Jeffrey Lorsch, president of Evergreen State Mortgage, a mortgage broker firm in Washington state.

Some HELOC lenders mandate that you take at least a minimum draw upon obtaining the loan. Other HELOC lenders require you to tap a set minimum amount of your home equity each time you write a check from your equity line of credit.

Even though a HELOC gives you great flexibility and ease of access, those features can be detrimental for the wrong borrowers. It's all too easy to get tempted to borrow against your home equity. If you use your home equity line of credit as a piggy bank, before you know it, you've overextended yourself.

It's also a bad idea to use a HELOC without first thinking about the time frame of your financial needs.

In Lorsch's opinion, HELOCs are best used to fund short-term needs -— "12 to 15 months maximum," he says, because their rates, which are tied to the prime rate, can move very quickly. "So in an increasing rate environment, you need to be careful with HELOCs," Lorsch says.

Though it's not likely, Lorsch says that in a worst-case scenario, even a HELOC with a 3 percent to 5 percent rate could shoot up to as much as 18 percent. So he cautions borrowers: "Ask yourself if your budget could handle that."

Foreclosure and taxes

With both home equity loans and HELOCs, your home is collateral for the loan. If you don't pay your primary loan or your equity loan, a lender could foreclose and seize the property.

Although you may have heard that the interest on home equity loans and HELOCs is usually tax deductible on loans up to $100,000, that's not quite the full picture. In truth, the interest you pay on a mortgage up to $1 million is tax deductible. If you have a home equity loan, that overall mortgage limit gets bumped up by $100,000 to $1.1 million, according to Rob Seltzer, a CPA who runs a firm bearing his name in Los Angeles.

So you might have a high-value property — worth, say, $650,000 — and you may have a $250,000 first mortgage on it and a $200,000 line of credit as well. Under this scenario, you'd have $450,000 in mortgage debt outstanding, and because you're well under the $1.1 million mortgage limit, the interest you pay on both loans would be tax deductible, Seltzer notes.

Watch out for the lure of minimum payments

If you decide to tap your home equity in order to consolidate debt, recognize the pros and cons of doing so.

"Home equity is a great tool if it's used responsibly," says Seltzer, "but it can also be a trap."

People looking to consolidate debt, such as credit cards or auto loans, benefit in two ways: "With home equity loans and HELOCs, you're not only getting a lower rate, you're also making payments that are tax deductible."

The downside, however, is that equity lines of credit only require you to pay interest in the early years of the loan. "People need to have discipline and not just essentially make minimum payments on HELOCs," he says.

Lorsch agrees, noting that's another way in which HELOCs can act like credit cards.

"During the first five or 10 years, during the draw period, most lenders only require you to pay interest, and many people do in fact only pay interest, not principal on HELOCs," Lorsch says. "But you can always pay more."