HELOC vs. Home Equity Loan: How To Choose

Home equity loans and home equity lines of credit (HELOC) are both worth considering if you want to tap into your home’s equity to get cash. While these loan products have many similarities, they aren’t quite the same.

Keep reading to learn more about these loan products, their benefits and drawbacks, and how to select the option that’s best for you.

What Is a Home Equity Loan?

Also referred to as a second mortgage, a home equity loan is a debt product that allows you to borrow against the equity in your home. Loan proceeds are dispersed in a lump sum, and you will make fixed monthly payments for a period of five to 30 years.

You can determine how much equity you have by subtracting your outstanding mortgage balance from the current value of your home.

To illustrate, if your original mortgage was $500,000, but you’ve paid down the balance by $125,000, you still owe $375,000. But if the home values in your area have skyrocketed due to market conditions, and your home is now worth $545,000, you have $170,000 in equity.

You generally won’t be able to borrow $170,000, though, as most lenders cap the loan amount at 75 to 80 percent of your total equity. In this case, your loan would be limited to $127,500 or $136,000. And if there are concerns about your ability to repay the loan, you could get approved for a lower amount.

Home Equity Loans Pros

There are several key benefits of home equity loans:

• The interest rate is fixed. You won’t have to worry about fluctuating interest rates, and you can save a bundle on interest if you pay off the loan early.
• Monthly payments are predictable. You will know the monthly payment for your home equity loan before you sign the dotted line, making it easier to budget for them.
• You may qualify for an extended repayment period. Some lenders offer repayment terms of just five years, but others give you up to 30 years to repay the loan.
• The interest paid on home equity loans may be tax-deductible. Consequently, you could save money at tax time.

Home Equity Loans Cons

As with any loan product, there are drawbacks to consider:

• You could lose your home if you fall on hard times. If you fall behind on your payments, the lender could foreclose on your home.
• If the market dips, you could be upside down in your loan. Consequently, it would be more challenging to sell your home without incurring a substantial financial loss.
• The monthly payments could be steep. Depending on your repayment term, the monthly payments on your home loan could stretch your budget too thin.

What is a HELOC?

A home equity line of credit (HELOC) is also based on the equity in your home. However, loan proceeds are not dispersed in a lump sum. Instead, you get access to a credit line (equal to your borrowing limit) to pull money from as needed. HELOCs are limited to 75 to 95 percent of your home’s equity minus what you owe on your loan.

Most HELOCs have a draw period of 10 years, followed by a repayment period of 20 years. You will make payments for a small portion of the outstanding principal balance and interest during the draw period. Once it ends, you will no longer have access to the funds.

HELOCs Pros

Here are some benefits HELOCs offer:

• Only borrow what you need. You can draw as little or as much as you’d like. If you only take what you need, you can avoid overspending and save on interest when you repay the loan.
• It’s easier to manage monthly payments. The draw period usually lasts up to 10 years, so you can borrow at your own pace and possibly pay down or eliminate the entire loan balance before the repayment period ends.
• Interest may be tax-deductible. Check with your accountant to confirm.

HELOCs Cons

You should also consider the potential drawbacks of HELOCs.

• Your property is at risk. Your home secures these loans, so missed payments could lead to the loss of your asset through foreclosure.
• Interest rates are variable. Consequently, monthly payments could fluctuate depending on market conditions.
• The lender could close your line of credit. Like credit cards, HELOCs are revocable if the lender reviews your credit profile and finds that your financial situation is declining. Some lenders also lower credit lines of close HELOCs if the housing market declines and decreases your home’s value.

Home Equity Loan vs. HELOC: Overview

Home equity loans and HELOCs are viable ways to tap into your home’s equity to get the cash you need. Both use your home as collateral and have other similarities, but there are also differences to consider.

HELOC vs. Home Equity Loan: Pros and Cons Compared

Both debt products allow you to use your home’s equity to fund renovation projects, pay off high-interest debt, take care of significant expenses, and the list goes on. Lenders also offer relatively generous loan limits and competitive interest rates to homeowners with good or excellent credit scores.

However, there are major drawbacks to both. For starters, homeowners have to put their homes up for collateral, which could prove to be a risky move in the future if financial troubles arise or the market declines. Furthermore, loan payments could mean bad news for your finances if you borrow more than you can afford to repay.

Key Differences Between a Home Equity Loan vs. HELOC

Both home equity loans and HELOCs are considered second mortgages, but there are a few key differences.

Payment Terms

Home equity loans give you the loan proceeds all at once, and you repay what you borrow over a five to 30-year period. But HELOCs grant you a credit line that you can draw against for 10 years, followed by a 20-year repayment period.

Home equity loans have fixed monthly payments the moment you borrow money. If you need more time to make payments toward the balance, a home equity line of credit may be the better choice.

Interest Rates

Interest on home equity loans is fixed, and the payments remain over the life of the loan. However, HELOCs come with fluctuating interest rates, and the monthly payments aren’t predictable.

HELOC rates can go down if the Federal Reserve reduces interest rates. It’s better to secure a fixed interest rate when rates are low, so you keep the low payments. The interest paid on home equity loans and HELOCs may be deductible on your federal income tax return.

Flexibility of Funds

You can use the funds from a home equity loan or a HELOC for any purchase. It’s your equity, and you don’t have to inform banks on how you intend to use your money.

HELOCs offer more flexibility since repayments are lower in the beginning. However, home equity loans have consistent monthly payments that won’t catch you by surprise.

Deciding Between a Home Equity Loan or HELOC

It’s a matter of personal preference and depends on your individual needs. Knowing the strengths and weaknesses of both financial products will help you make a better decision. These are some of the key details to consider.

Factors to Consider When Choosing

When choosing a home equity loan or a HELOC, you should consider several factors. These are some things to keep in mind:

• Your monthly budget: People with tighter monthly budgets may prefer a HELOC.
• Interest rates: If rates are low, a fixed-rate loan is better than a variable-rate line of credit.
• Certainty: Home equity loans have predictable monthly payments. Variable rates make HELOCs less predictable.
• Flexibility: You can use HELOC funds without initially worrying about high monthly payments. With a home equity loan, you immediately start to make monthly payments. You only pay interest on a HELOC when you borrow against it. It’s possible to get a HELOC, hold onto it, and not pay interest until you need to access funds.

Assessing Your Financial Situation

You should assess your ability to cover monthly payments for your loan balance before committing to a financial product. People with tighter budgets may benefit from a home equity line of credit. You also don’t need to use a HELOC right away. You only get charged interest if you borrow against the credit line. However, you have to pay interest on a home equity loan immediately after you receive the lump sum.

Qualifying for a HELOC or Home Equity Loan

Most lenders have similar requirements for home equity loans and home equity lines of credit. You will need a credit score in the 600s and a sufficient debt-to-income ratio. Each lender has different requirements for their home equity loans and lines of credit.

How to Get a HELOC or Home Equity Loan

You can reach out to banks, credit unions, and online lenders to compare your options. Creditors often list their requirements on their websites. Applying for several loans and credit lines in a 14-45-day window can reduce the impact of hard credit checks on your credit score.

FAQs About Home Equity Loans vs. HELOCs

Below, you will find frequently asked questions about home equity loans and HELOCs.