What is Home Equity Debt?

One of the major advantages to owning a home is the opportunity for the owner to take out a home equity loan or line of credit to borrow money. They offer a great way to borrow money, but it’s important to know exactly how it works. The owner uses their home’s equity, which refers to how much the home is worth versus how much is owed on the mortgage, as collateral for the loan. The amount they can borrow generally depends on the home’s equity and their credit history. Many home owners have found home equity loans or lines of credit useful in financing home improvements, paying off other debts, or using it for their child’s college education. If the home equity debt isn’t paid off before, it is expected to be paid off by the time the house is sold.

Two Types of Home Equity Debt

There are two basic forms of home equity debt, a home equity loan (HEL) and a home equity line of credit (HELCO). They are completely different from each other, but both are often referred to as a second mortgage since they use the home as collateral. Here’s a basic look at both types:

Home Equity Loan

A home equity loan is similar to a conventional loan in that it gives the borrower a one time lump sum. The loan is then paid back over time with a fixed interest rate. Typically the home owner simply makes a payment each month until it’s finally paid back, usually over a 10-30 year period. Further money cannot be borrowed until the original home equity loan is paid back in full.

Home Equity Line of Credit

A home equity line of credit is much different than a home equity loan in that it is more like a credit card than a loan. The lender sets a time limit for the loan and the home owner is able to borrow a specified amount of money from a revolving balance. As the home owner pays off the principal of the loan, they can continue to withdraw money from it. A HELCO also differs from a home equity loan because it has a variable interest rate and will have different monthly payment amounts. As you can see, this offers some more flexibility than a HEL, but could cost more with the variable interest rate.