HELOC’s vs Home Equity Loans: Similarities, Differences, and Why I Don’t Use Either of Them
Tapping home equity for cash is a common practice, but it’s not often a very good decision. Home equity loans and HELOCs actually reduce one’s net worth. We recommend cash-flowing home improvements, life events, and your emergency fund instead of using home equity to finance any of these things.
Tapping home equity is a common way to obtain cash quickly; assuming you have any equity available.
Most people use home equity loans or HELOCs (they’re different, but we’ll cover that in a sec) to pay for home renovations, weddings, or debt reduction/consolidation.
Additionally, HELOCs are commonly seen by many as a source of opportune emergency funds.
In this post, we’ll discuss what each of these loans is, how they work, and why we don’t use them.
Home Equity Loans
A home equity loan is essentially a second mortgage. Borrowers take out a loan using a percentage of the home’s available equity as collateral.
One key benefit of using home equity for a loan is that it contains collateral for the lender, resulting in lower risk to them and a lower interest rate for you.
Of course, this also means you’ll have a second lien on your home and another claimant if you can’t pay your bills and are forced into foreclosure.
Home equity loans will require many of the closing costs that normally come with a mortgage because it’s essentially another mortgage.
Finally, these are typically issued in one lump sum of cash and repaid with a structured and fixed monthly payment plan.
HELOC
A home equity line of credit (HELOC) is a revolving loan issued with a maximum draw amount and based on a percentage of your home’s available equity.
A HELOC comes with collateral for the lender, but the interest rate is typically variable instead of fixed. Many times, this results in a lower interest rate than a home equity loan.
Another benefit of HELOCs is that they don’t have much, if any, closing costs.
As a type of revolving credit, HELOCs are usually not distributed until there is a need by the borrower. The borrower can use all or a portion of the line of credit, though some lenders may require a minimum distribution at the time of closing.
Unused credit in the HELOC does not accumulate interest. The flexibility to use funds when needed makes the HELOC an attractive option for quick cash or even to serve as an emergency fund (more on that later).
Banks usually provide multiple ways to make distributions from the HELOC through credit cards connected to the account, online transfers, or checks.
HELOCs are typically issued for a 10-year draw period in which the borrower is allowed to make withdrawals against the line of credit.
No further credit is extended after year 10 and repayments have to be made for any outstanding balances over the course of the next 20 years though this could vary based on the lender.
Typically, payments can be made on an interest-only basis in the first ten years meaning the repayments in the second 20-year period can be significantly higher when the principal is collected in the monthly payment.
Used this way, a HELOC can become a sort of financial timebomb. In many cases, the monthly payments nearly double after the draw period closes and the repayment period begins.
Why we don’t use these loans
If you’re new to this site, you may not be aware that we’re not big fans of debt.
Basically, we believe debt is one of the most destructive forces to wealth building there is.
While compound interest works for you in investing, it works against you when borrowing. We talk more about why we don’t like debt in our post about the 3rd milestone on the Next Dollar Roadmap, paying off toxic debt.
If you read that post, you may note that we’re not totally against debt for the purchase of a home since it is an appreciating asset.
You might also think that since home equity is a debt against an appreciating asset we’d recommend it too, but that’s not the case.
First, home equity loans and HELOCs both have higher rates than a mortgage.
Also, in the case of HELOCs, the debt is very accessible which may tempt one to borrow against their home for frivolous reasons.
A first mortgage is an excellent tool for beginning the process of procuring one of the most common sources of net worth, a home.
However, borrowing against your equity is only giving away the wealth you’ve accumulated after steadily paying your mortgage each month.
In summary, home equity loans and HELOCs reduce your net worth. They don’t build it.
If you are in a pickle, need some cash, and have no other option but debt, a cash-out refinance may be a better option than either the home equity loan or the HELOC since it will at least come with a lower rate and only one lien holder instead of two.
Why you shouldn’t use a HELOC for an emergency fund
I know plenty of people that understand the importance of having an emergency fund and seek to satisfy that need through a HELOC.
We cover fully funded emergency funds in milestone 4 of the Next Dollar Roadmap. In that post, we highlight some critical characteristics of emergency funds, one of which is accessibility.
After all, emergency funds aren’t very useful if you can’t get to them in an emergency.
While HELOCs usually come with sufficiently convenient methods for tapping the line of credit, they may not be there when you need them most.
You see, depending on the terms of your HELOC, the bank may be allowed to terminate your credit line at any time they need to.
And when will they need to? Probably when the economy rolls into the ditch and a sudden emphasis is placed on liquidity.
And when will you need the emergency fund? Probably when the economy rolls into the ditch and a sudden emphasis is placed on liquidity.
Imagine losing your job due to economic forces and being unable to tap that line of credit when you needed it most. Bummer.
The phrase “cash is king” isn’t simple hyperbole. Do this the right way and hold your emergency funds in cash that you have access to when you need it.
Furthermore, if you’ve got ambitions to renovate or pay for a dream vacation or wedding, ask yourself if it’s really worth the debt you’ll have to take on to pay for it. It probably isn’t.
Take our word for it, good things come to those who are patient and build wealth slowly. Debt, including home equity loans and HELOCs, has the opposite effect and will only serve to push you further away from financial independence.
