Difference between a home equity loan and line of credit
When you choose how to borrow from the available Glossary Term: equity in your home, you are often making the choice between a home equity loan and a home equity line of credit. The two differ in the way you access your loan funds, and by the Glossary Term: interest rates they offer. Home equity loans have a fixed-rate, while home equity lines of credit have a variable rate.
Fixed-rate option: home equity loan
A home equity loan allows you to borrow the entire amount of your loan all at once. This fixed-rate loan generally has a higher interest rate than a home equity line of credit; however, with a fixed rate your monthly payment will stay the same for the entire term of the home equity loan. This could be beneficial if interest rates were to rise above your fixed rate. It also protects you from payment surprises and is very straightforward. This loan type may be a good option for you if you have a monthly budget you need to stick to, or if you prefer payment stability.
Variable-rate option: home equity line of credit
A home equity line of credit allows you to use as little or as much of your credit line as you need, up to your pre-set limit. Home equity lines of credit generally offer lower rates than fixed-rate home equity loans; however, they come with variable rates that change periodically according to the changes of a financial index, for example, The Wall Street Journal Prime Rate. The interest rate on the line of credit is determined by adding the rate of the index (which can vary over time) to a margin (which is determined by your lender and remains fixed for the life of the line of credit). The interest rate will adjust with movement in your loan's financial index, so your payment may vary from month to month. If the index goes up, so will your rate and interest payment, whereas if the index goes down, so will your rate and interest payment.
With variable-rate lines of credit, there are three major considerations:
- The rate is subject to change and could increase, which would also increase your interest payments. This can make budgeting for the future unpredictable.
- Your lender may also offer you a fixed-rate loan option. Bank of America home equity lines of credit include this fixed-rate conversion option. This would allow you to convert all or just a portion of the outstanding variable rate balance on your home equity line of credit to a fixed rate, resulting in stable payments for the portion of the balance you convert to that fixed rate. You may choose this option if you want to be protected from rising interest rates.
- Most home equity lines of credit provide an interest-only payment option during the Glossary Term: draw period (typically the first 10 years of the loan). This could allow you to delay making principal payments, as you’d be making monthly payments of only the interest on what you’ve borrowed. After the draw period ends, your repayment period (which is typically about 15 years) begins. If only interest payments were made during your draw period, monthly payments could significantly increase during your repayment period when the required monthly payments started to include principal plus interest.
Even if your home equity line of credit has an interest-only minimum payment, it’s recommended you pay more than the minimum so that you’re paying down your principal as well as the interest on what you’ve borrowed.