HELOC vs. Home Equity Loan: How Do They Work?
Updated May 1, 2024 at 10:14 am
If you own a home, you may use your home equity to meet a variety of financial goals. Whether you’d like to consolidate high-interest debt, fund a home renovation or go on vacation, a home equity line of credit (HELOC) or home equity loan can come in handy. But, how do you know which one to choose? Our HELOC vs. home equity loan comparison below can help you determine the ideal option for your unique situation.
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Vault’s Viewpoint on HELOCs vs. Home Equity Loans
- Both HELOCs and home equity loans allow you to tap into your home’s equity.
- While a HELOC is a revolving line of credit, a home equity loan provides a lump sum of money upfront.
- While HELOCs are more flexible, home equity loans come with predictable monthly payments you can easily budget for.
What Is Home Equity?
Before we compare a HELOC to a home equity loan, let’s define home equity. Put simply, home equity is the difference between what you currently owe on your mortgage and your home’s appraised value. Let’s say your home is worth $400,000 and your outstanding mortgage balance is $200,000. In this scenario, you have a total of $200,000 or 50% home equity.
Most lenders require you have at least 20% equity in your home before you tap into it with a HELOC or home equity line of credit. To build home equity, you can make a large down payment, increase your monthly payments, invest in renovations that offer a good ROI or simply wait for your home equity to go up.
HELOC vs. Home Equity Loan
Both a HELOC and home equity loan allow you to tap into your home equity. However, the most noteworthy difference between these second mortgages is in the way you receive the funds. Here’s a closer look at each product.
What Is a HELOC?
Similar to a credit card, a HELOC acts as a revolving line of credit. This means you can withdraw as much or as little money as you’d like, up to a set credit limit. A HELOC has two phases, including the draw period and the repayment period. During the draw period, which usually lasts 10 years, you can access funds.
You will have to pay interest on the amount you borrowed, but principal payments are optional. Once the repayment period kicks in, which is often 20 years, you won’t be able to withdraw more money. This is when you’ll need to make both your interest and principal payments.
Pros and Cons of a HELOC
The benefits and drawbacks of a HELOC include:
Pros
- Flexibility: You can withdraw funds at any time, up to your set credit limit. This is a huge plus for emergency expenses or ongoing projects, like home improvements.
- Interest-Only Draw Period: You’ll only have to pay interest charges during the draw period. Therefore, you can enjoy very low payments for the first decade of your loan.
- Potential Tax Deductions: If you put your HELOC proceeds toward certain home renovations, you may be able to deduct the interest from your taxes. Be sure to check with a tax professional for more information.
Cons
- Variable Interest Rates: Most HELOCs come with variable interest rates. It can be difficult to budget for your monthly payments because they can go up or down, depending on market conditions.
- Temptation to Overspend: Since a HELOC lets you access money as you wish, it can be easy to borrow more than you can afford. A HELOC may steer you into a cycle of debt.
- Risk of Foreclosure: A HELOC is a secured loan that uses your home as collateral. If you default on your payments, the lender has the right to foreclose on your property.
What Is a Home Equity Loan?
A home equity loan can give you the chance to borrow a larger sum of money than alternative financing solutions, like credit cards or personal loans, for example. Unlike a HELOC, a home equity loan offers a lump sum of cash upfront. You’ll repay what you borrow over a specific term, usually via fixed monthly payments.
While every lender has its own requirements, most home equity loans come with a term that may range from five to 30 years. Once you use up all your funds, you’ll need to reapply for another home equity loan to access more. A home equity loan is similar to a personal loan but typically comes with lower interest rates and longer repayment terms.
Pros and Cons of a Home Equity Loan
Here are the advantages and disadvantages of a home equity loan.
Pros
- Consistent Monthly Payments: In most cases, home equity loans have fixed interest rates. This means you can budget for your monthly payments in advance because they will remain the same over the life of the loan.
- Lump Sum Funding: With a home equity loan, you’ll receive all of your money at once. You may find this helpful if you have a large, immediate expense, such as debt consolidation or a medical bill.
- May Be Tax Deductible: If you use the funds to make certain home improvements, you might qualify for a tax deduction. Reach out to a tax advisor for more details.
Cons
- Closing Costs: Most home equity loans charge closing costs that can increase your overall cost of borrowing. You may pay anywhere from 2% to 6% of your total loan amount.
- Fixed Borrowing Amount: Once you receive your funds from a home equity loan, you won’t have access to anymore. You’ll need to apply for another loan to receive additional money.
- Chance of Losing Your Home: A home equity loan puts your property on the line. If you fail to make your monthly payments, the lender may foreclose on the home you used as collateral.
Which Is Better, a HELOC or Home Equity Loan?
Whether a HELOC or home equity loan is better depends on your particular situation. A HELOC is likely your best bet if you’re unsure of exactly how much money you’ll need; it can give you the freedom to withdraw funds as various expenses pop up.
You may also find a HELOC beneficial if you prefer smaller monthly payments initially. A home equity loan, on the other hand, might make more sense if you want one lump sum of cash because you need a set amount of money for a specific purpose, like a new roof or car repair.
In addition, a home equity line is ideal if you prefer fixed monthly payments that will remain the same until you repay your loan. Lastly, it may be the smarter choice if you’d like to resist the temptation to overspend, as this is much easier to do with a HELOC.
Alternatives to HELOCs and Home Equity Loans
Before you move forward with a HELOC or home equity loan, you may want to consider these alternative options.
- Home Equity Sharing Agreement: A home equity sharing agreement is another home equity product. You receive funds in exchange for a percentage of your home’s future appreciation.
- Cash-Out Refinance: Also known as a form of home equity financing, a cash-out refinance replaces your current mortgage with a new one with a higher difference. You’ll pocket the difference as cash.
- Reverse Mortgage: If you’re at least 62, a reverse mortgage can allow you to borrow against your home equity. The proceeds you receive from it pay off your current mortgage and you can then use the remaining money however you’d like.
- Credit Cards: Credit cards are similar to a HELOC in that they offer a line of credit. If you have a smaller expense and know you’ll be able to pay off your balance in full at the end of every month, they can save you money on interest—especially with a 0% APR credit card.
- Personal Loans: Like home equity loans, personal loans offer a one-time payment and fixed interest rates. However, they’re unsecured, and you’ll need good-to-excellent credit to qualify for the lowest interest rates.
- Rent-Back Agreements: Often referred to as sale-leasebacks, rent-back agreements allow you to sell your home and continue to live in it for a specific period of time. You’ll act as a temporary tenant and reap the financial benefits of selling your home while still being able to live there.
Frequently Asked Questions
What Are the Requirements for a HELOC and Home Equity Loan?
Eligibility criteria for a HELOC and home equity loan depends on the lender. However, typically you’ll need a credit score of at least 660, a minimum of 20% equity in your home and a debt-to-income ratio of no more than 43%.
How Much Can I Borrow With a HELOC or Home Equity Loan?
Most lenders will let you borrow up to 85% of your home’s value. If your home is worth $300,000, for example, you may qualify for up to $255,000 between your first mortgage and your HELOC or home equity loan.
What Is Better for Home Improvements: A HELOC or Home Equity Loan?
Since both HELOCs and home equity loans offer tax deductions, they are both solid choices for home improvements. If you don’t know exactly how much your project will cost you, however, you may benefit from the flexibility of a HELOC.
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