As a homeowner, you have access to a powerful financial tool known as home equity. Home equity can be used to finance a number of projects or to pay off significant debt at an ultimately low cost. Understand how to make home equity work to your advantage by first making sense of home equity loans and home equity line of credit basics.

Home equity basics

Home equity, in a nutshell, is the value of the unencumbered interest you have in your own property. Essentially, it’s the difference between the fair market value of your home and the unpaid balance of your mortgage.

Another way to look at equity is to see it as the amount of money you have invested in your house. For example, if your original mortgage loan was for $300,000 and you’ve since paid $75,000 of that loan, then you have $75,000 worth of equity in your house.

Home equity is a powerful tool because it can be used as collateral when you need money. You can apply home equity collateral by taking out a home equity loan or a home equity line of credit (also known as a HELOC). Such forms of financing are favorable to borrowers because any interest paid is partially tax deductible.

Both a home equity loan and a home equity line of credit are commonly referred to as second mortgages. This is because they are secured by your tangible property, just as your original mortgage is secured by your property.

Though most original mortgages run as long as 30 years, home equity loans and home equity lines of credit have shorter terms. These terms vary from between five and 15 years.

Home equity loans

A home equity loan is also known as a term loan. In short, it is a one-time lump sum paid to a borrower over a set amount of time. Home equity loans come with a fixed interest rate and require the same payment from month to month.

The interest rate for home equity loans is based on the Prime rate and usually includes an additional margin, typically set by your lender.

Home equity loans are commonly used by consumers to finance major home remodeling projects or to pay for outstanding medical bills or college education. In many cases, consumers take out home equity loans in order to pay off other forms of consumer debt such as outstanding credit card bills, personal loans, or car loans.

Home equity lines of credit (HELOCs)

A home equity line of credit is a lot like a credit card. You are given a maximum amount that you are allowed to borrow along with a specific time limit set by your lender – also known as the life of your line of credit.

During the life of your line of credit you are able to withdraw money as you need it. You are then billed on a monthly basis for a minimum payment plus a finance charge.

To access money from your HELOC, you are given either checks or a credit card. Most lenders require that you withdraw a certain minimum amount every time you access your line of credit. In many cases, you’re also required to keep a minimum amount outstanding.

A home equity line of credit offers you more total flexibility than a home equity loan. This is because each payment you make toward the principal allows your credit to expand again so you can reuse it.

For example, pretend you have a $15,000 line of credit. Say you borrow $10,000 from that credit line, leaving you with $5,000 in available credit. Then say you pay back $8,000 toward your principal. This payment, combined with your existing $5,000 in credit, bumps you back up to a total of $13,000 available in credit.

One of the major differences between a home equity line of credit and a home equity loan is the fact that a HELOC has an adjustable interest rate. A HELOC functions as a revolving line of credit where you’re able to take out what you need as you need it. This is in contrast to the one-time lump sum payment of a home equity loan.

At the end of the term for your HELOC, your total balance must be paid off. In some cases, lenders will allow a renewal.

Benefits of home equity financing

Any type of financing through home equity offers two major benefits. The first is that you’ll nearly always land a lower interest rate on a home equity loan or line of credit than you would with any other type of consumer loan.

The second benefit is that any interest payments you make on your loan or line of credit become an allowed tax deduction at the end each tax year.

Either way, home equity financing is an attractive way to finance necessary home improvement projects or other types of needs.