Home Equity Loans vs. HELOCs: An Overview
Home equity loansandhome equity lines of credit (HELOCs)are loans that are secured by a borrower’s home, but these loan types have different payment structures and interest rates. The best home equity product for you will depend on your needs, goals, and spending habits.
Because both use your home as collateral, they usually have much better interest terms than personal loans, credit cards, and other unsecured debt. However, consumers should be cautious of using either. Racking up credit card debt can cost you thousands in interest if you can’t pay it off, but becoming unable to pay off your HELOC or home equity loan can result in losing your home. Let's take a look at how these two products differ.
Key Takeaways
- Home equity loans and home equity lines of credit (HELOCs) are different types of loans based on a borrower’s equity in their home.
- A home equity loan comes with fixed payments and a fixed interest rate for the loan term.
- HELOCs are revolving credit lines with variable interest rates and, as a result, variable minimum payment amounts.
- The draw periods of HELOCs allow borrowers to withdraw funds from their credit lines as long as they make interest payments.
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Home Equity Loan
A home equity loan is a fixed-term loan granted by a lender to a borrower based on the equity in their home. Borrowers apply for a set amount and, if approved, receive it in a lump sum upfront. The home equity loan has a fixed interest rate and a fixed payment schedule for the loan term. A home equity loan is also called a home equity installment loan or an equity loan.
The equity in your home serves as collateral, which is why it is called a second mortgage and works just like a conventional fixed-rate mortgage. You need to have enough equity in the home, which means that the first mortgage must be paid down enough to qualify the borrower for a home equity loan.
To calculate your home equity, estimate the current value of your property by looking at a recent appraisal or using the estimated value tool on a website like Zillow, Redfin, or Trulia. Be aware that these estimates may not be 100% accurate. Subtract the total balance of what you owe from your home's value to get the equity.
The loan amount is based on different factors like the combined loan-to-value (CLTV) ratio. You can usually borrow up to 85% of the property’s appraised value.
A home equity loan’s interest rate is fixed, meaning the rate doesn’t change over the years. Also, the payments are fixed, equal amounts over the life of the loan. A portion of each payment goes to the loan's interest and principal.
Repayment generally ranges between five and 30 years, but the length of the term must be approved by the lender. Whatever the period, borrowers will have stable, predictable monthly payments to make for the life of the equity loan.
Home Equity Loan
Pros
Fixed amount, making impulse spending less likely
Fixed monthly payment amount makes it easier to budget
Lower interest rate
Cons
Can’t take out more for an emergency without another loan
Have to refinance to get a lower rate
May lose your home if you default
A home equity loan provides you with a one-time lump sum payment that allows you to borrow a large amount of cash and pay a low, fixed interest rate with fixed monthly payments. This option is potentially better for people who:
- Are prone to overspending
- Like a set monthly payment for which they can budget
- Have a single large expense for which they need a set amount of cash, such as college tuition
Home Equity Line of Credit (HELOC)
A home equity line of credit is a revolving credit line that allows the borrower to take out money against the credit line up to a preset limit, make payments, and then take out money again. A HELOC allows you to use it as needed as long as you make your payments. The credit line remains open until its term ends. Because the amount borrowed can change, the borrower’s minimum payments also change based on how it's used.
'In the short term, the rate on a [home equity] loan may be higher than a HELOC, but you are paying for the predictability of a fixed rate," said Marguerita Cheng, certified financial planner and chief executive officer (CEO) of Blue Ocean Global Wealth
HELOCs are secured by the equity in your home. Unlike other types of revolving credit (think of credit cards, which are usually unsecured), you could lose your home if you default and stop making payments.
A HELOC has a variable interest rate, meaning the rate can increase or decrease over the years. As a result, the minimum payment can increase as rates rise. However, some lenders offer a fixed interest rate for HELOCs. The rate the lender offers depends on your creditworthiness and how much you’re borrowing.
Both home equity loans and HELOCs offer better interest rates than other common options for borrowing cash, with the major downside that you can lose your home to foreclosure if you don't pay them back.
HELOC terms have two parts:
- The draw period, during which you can withdraw funds, might last 10 years. When the draw period ends, you cannot borrow any more money.
- The repayment period might last another 20 years, making the HELOC a 30-year loan.
During the HELOC’s draw period, you still have to make payments, which are typically interest-only. As a result, the payments during the draw period tend to be small. The payments become substantially higher throughout the repayment period because the principal amount borrowed is now included in the payment schedule along with the interest.
It’s important to note that the transition from interest-only payments to full, principal-and-interest payments can be quite a shock, and borrowers need to budget for those increased monthly payments.
HELOC Pros and Cons
Pros
Choose how much (or little) to use of your credit line
Variable interest rates mean rates and payments may drop based on market conditions and credit score
Lower interest rate than unsecured loans
Credit line available for emergencies
Cons
Harder to budget because of fluctuating interest rates
Variable interest rates mean rates and payments may rise based on market conditions and credit score
May lose your home if you can’t make payments
Easy to impulse-spend up to your credit limit
HELOCs give you access to a variable, low-interest-rate credit line that allows you to spend up to a certain limit. These lines of credit are a potentially better option for people who want access to a revolving credit line for variable expenses and emergencies that they can’t predict.
For example, a real estate investor who wants to draw on their line to purchase and repair the property, then pay down their line after the property is sold or rented and repeat the process for each property would find a HELOC a more convenient and streamlined option than a home equity loan.
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Key Differences
Both home equity loans and HELOCs allow consumers to gain access to funds that they can use for various purposes, including consolidating debt and making home improvements. Generally, borrowers can access up to 85% of their home's equity, which is the difference between the value of the home and the outstanding mortgage balance. Let's look at some of the key differences between these two credit products.
Home Equity Loans
Home equity loans give the borrower a lump sum upfront and have fixed interest rates. They are a good choice if you know exactly how much you need to borrow and how you want to spend the money. When approved, you’re guaranteed a certain amount, so they can help with big expenses such as paying for a children’s college education, remodeling, or debt consolidation. In return, borrowers make fixed payments over the life of the loan.
HELOCs
A HELOC helps if you aren’t sure how much you’ll need to borrow or when you’ll need it. It gives you ongoing access to cash for a set period—sometimes up to 10 years. You can borrow against your line, repay it all or in part, and then borrow that money again later, as long as you’re still in the HELOC’s draw period. They come with a variable interest rate, and the payments are not usually fixed.
They can be useful as a home improvement loan because it gives you the flexibility to borrow as much or as little as you need. If you need more money, you can get it from your line of credit (as long as it's available) without having to reapply for another mortgage loan.
Keep in mind that an equity line of credit is revocable—just like a credit card. If your financial situation worsens or your home’s market value declines, then your lender could decide to lower or close your credit line. So, although the idea behind a HELOC is that you can draw upon the funds as you need them, your ability to access that money isn’t a sure thing.
Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on characteristics like race, religion, sex, or age, file a report with the Consumer Financial Protection Bureau (CFPB) or the U.S. Department of Housing and Urban Development (HUD).
Will HELOC Rates Fall in 2024?
Although some analysts predict lower HELOC rates in 2024, nothing is certain. Getting a HELOC may be tougher than it was a few years ago. In 2020, two major banks—Wells Fargo (WFC) and JPMorgan Chase (JPM)—put a freeze on new HELOCs and haven't resumed offering these products as of this writing.
There was initially some confusion about whether homeowners would be able to deduct the interest from their home equity loans and HELOCs on their tax returns following the passage of the Tax Cuts and Jobs Act (TCJA). Unlike before the law, homeowners can't deduct interest for home equity loans and HELOCs unless the funds are used to construct, purchase, or make improvements to your home, and the money that you spend on such improvements must be spent on the property that serves as equity for the loan.
In other words, you can no longer deduct interest from these loans if you use the money to pay for your child's college or to eliminate debt. The law applies to tax years through 2025. Deductions are limited to the interest on qualified loans of $750,000 or less ($375,000 for someone who is married, filing separately). There are additional rules, especially if you also have a first mortgage, so be sure to check with a tax expert before using this deduction.
When Is a Home Equity Loan Better Than a Home Equity Line of Credit (HELOC)?
A home equity loan is a better option than a home equity line of credit (HELOC) if:
- You know the exact amount that you need for a fixed expense.
- You want to consolidate debt but don’t want to access a new credit line and risk creating more debt.
- You live on a fixed income and need a set monthly payment that doesn’t fluctuate.
When Is a HELOC Better Than a Home Equity Loan?
A HELOC is a better option than a home equity loan if:
- You need a revolving credit line to borrow from and pay down variable expenses.
- You want a credit line available for future emergencies.
- You are deliberate in your spending and can control impulse spending and a variable budget.
Which Gets Me Money Faster: A HELOC or a Home Equity Loan?
If you need money as quickly as possible, a HELOC will often process slightly faster than a home equity loan. Multiple lenders advertise home equity loan processing timelines of around 55 days, whereas some lenders advertise that their HELOCs can close in as little as two weeks, but may take up to six. The actual closing time will fluctuate based on the amount borrowed, property values, and the borrower's creditworthiness.
What Is a Good Alternative to a HELOC or a Home Equity Loan?
You can use a cash-out refinance or a loan from your 401(k) if you need a large lump sum for a fixed expense. If you want access to a credit line with a low interest rate, then a credit card with a 0% annual percentage rate (APR) promotional interest rate has an even better interest rate than a HELOC, provided that you pay it off before your introductory rate period expires. If you don’t mind slightly higher interest rates and want to avoid the risk of foreclosure, then a personal loan is a solid alternative. Each option has pros and cons and should be considered carefully.
What Are the Requirements for a HELOC or a Home Equity Loan?
Generally, borrowers for either a HELOC or a home equity loan need:
- More than 20% equity in their home
- A credit score greater than 680
- Stable, verifiable incomes
- Debt-to-income ratio of no more than 43%
It is possible to get approved without meeting these requirements by going through lenders that specialize in high-risk borrowers but expect to pay much higher interest rates. If you are a high-risk borrower, it may be a good idea to seek out a credit counseling service for advice and assistance before signing up for a high-interest HELOC or home equity loan.
The Bottom Line
There are many factors to consider if you need to take this step. Home equity loans provide the stability and predictability of fixed rates and payments while HELOCs come with variable rates. Be sure to also understand how you'll use the money, what may happen with interest rates, your long-term plans, and your risk tolerance.
If you’re uncertain about how much you need to borrow and you’re comfortable with the variable interest rate, then a HELOC might be your best bet. As with any credit product, it’s important not to get overextended and borrow more than you can pay back because your home is the collateral for the loan.
