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What are Home Equity Loans?

A home equity loan is an agreement to borrow a lump sum against the equity in a home. It is similar to a normal mortgage or car loan in that you agree to pay off the loan over a set period of time with regular payments. Depending upon the loan, the interest rate can either be fixed or adjustable.

A home equity line of credit, in contrast, is an agreement that you may, but are not required to, borrow any amount up to the maximum amount approved by the lender.

The loan is usually divided up into two periods:

  • the draw period, in which funds can be drawn upon up to the credit limit
  • the repayment period, during which the amount borrowed must be repaid.
Draw periods usually range from 5 to 10 years, during which the borrower is only required to pay interest on any average outstanding balance carried during the month. Borrowers usually "draw" on their line of credit by writing a check or using a debit card issued by the lender. After the drawing period ends, the outstanding balance is converted into an adjustable rate home equity loan amortized over 10 to 20 years. The payment schedule during this repayment period is similar to a normal adjustable home equity loan.

How to choose between a home equity loan and a line of credit

This choice is not always straightforward. In general, the line of credit offers more flexibility while a home equity loan can offer a fixed rate for the term of the loan.

If you know when and how much you will need to borrow, and don't intend to borrow more money in the future, a home equity loan is usually more suitable. It allows borrowers, if they choose, to lock in a fixed rate for the term of the loan.

A line of credit, on the other hand, will allow you to borrow only the amount you need when you need it. If you will only need to borrow smaller amounts and intend to pay the principal down quickly, a line of credit can minimize your interest expense.

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