Difference Between Home Equity Loan and HELOC

A home equity loan and home equity line of credit will both allow you to borrow money based on your home's equity, meaning your house's market value minus your remaining mortgage balance. However, the main difference between HELOC and home equity loan offerings is that you get a lump sum for a home equity loan compared to a revolving credit line for a HELOC. Other differences involve interest rates, repayment terms and associated fees. To select the right option for you, you'll want to compare the difference between HELOC and home equity loan benefits and risks, along with the reason you need the money.

TL;DR (Too Long; Didn't Read)

Typically having a fixed interest rate and predictable monthly payments, a home equity loan lets you borrow a lump sum based off your home's equity. Often with a variable interest rate, a HELOC involves extending a revolving credit line to you, where you pay only interest during a draw period and later enter the full repayment period.

What's a Home Equity Loan?

When you take out a home equity loan, you're borrowing up to the amount of equity you have in your property as a lump sum of cash. This acts as a second mortgage where your property is the collateral for the loan. Similar to your first mortgage, you'll make fixed monthly payments, typically for 10 to 15 years, until you pay the home equity loan off. These loans usually come with a fixed interest rate, although some lenders offer variable rates.

Since you receive all the money at one time, you might use a home equity loan for a large one-time expense. For example, you may make a major purchase, use the funds for an emergency medical bill, remodel your home or pay off existing debts like student loans and car loans.

What Is a HELOC?

Like a home equity loan, a HELOC lets you borrow funds based on the equity of your property with your home used as the security in case you default. But a major difference between HELOC and home equity loan options is that rather than giving you the amount in a lump sum, your lender extends a revolving line of credit for you to withdraw from as necessary, similar to using a credit card. The interest paid is usually variable, meaning it can go up and down over your loan term.

You'll have a drawing period of possibly five to 10 years, during which you make only interest payments on what you withdraw from the line. After your drawing period expires, you'll enter a repayment period, often 20 years, during which you'll pay larger principal and interest payments like with a standard home equity loan.

Since you can borrow only as much as you need during the draw period, you may use a HELOC to pay for expenses that come up over time. For example, you may spend several years doing various home upgrades over the drawing period or paying off debts and other expenses as they arise.

HE Loan Pros and Cons

A big advantage of a home equity loan is that since you get the funds all at once and usually have a fixed interest rate, you'll know exactly how much you'll borrow and how much you'll pay each month. This can help you better plan for making large purchases as well as more easily budget for your monthly payments. There is also no restriction on what you use the funds for, although you can get the benefit of deducting mortgage interest when you use the funds toward making substantial home renovations.

One disadvantage of a home equity loan is that while your interest rate will probably be lower than that of a credit card or personal loan, you'll probably still pay a slightly higher rate than you would with a HELOC. For example, as of September 2019, Value Penguin noted an average home equity loan rate of 5.76 percent compared to 5.51 percent for a HELOC. Home equity loans also usually come with closing costs, between 2 and 5 percent of the amount you borrow, along with potential points. Lastly, if you default on the loan, you can end up having your home taken away the same way you could if you defaulted on your mortgage.

HELOC Pros and Cons

If you're not sure how much you'll need to borrow or just want a line of credit available for unexpected expenses, then the flexibility you get with a HELOC can be a clear advantage. You also won't have to start making any payments until you actually borrow from the credit line, and your payments will be interest only during your drawing period. You can also save in terms of lower interest than with a standard home equity loan. You may avoid having to pay expensive closing costs and application fees, depending on your lender.

LendingTree suggests you may get approved for a HELOC more quickly than for a home equity loan that requires a more involved process. Further, like with a home equity loan, you get the benefit of being able to deduct mortgage interest as long as you use the money for major home renovations that lead to an increased property value.

These benefits, though, come with less predictability when it comes to your payments and additional penalties and fees. Unless you have a fixed interest rate, your payments can go up and down according to market rates, so your budget will need to adapt whenever these changes occur. You may also have to pay an annual fee to have the HELOC along with additional charges due to inactivity, early cancellation or prepayment. Along with the risk that comes with using your home as collateral, a HELOC gives lenders freedom to change how much your line is, or even stop you from using it entirely if your financial situation or home value deteriorates.

Understanding Application Requirements

Whether you apply for a home equity loan or HELOC, you'll need to meet your lender's requirements regarding your ability to pay, credit score, loan-to-value ratio and employment. This typically means having a credit score of at least 620, a maximum debt-to-income ratio of 43 to 50 percent (depending on the lender) and minimum equity of 15 to 20 percent of your home's value. Your lender will also look at your current payment history for other debts and assess the stability of your income to determine if you're a good candidate.

Making Your Decision

Your reason for borrowing the funds and your tolerance for uncertainty for interest rates and monthly payments will play a part in deciding whether a home equity loan or HELOC makes sense for you. If you need a large amount of money at one time and like knowing the exact payment amount you'll pay over the term of the loan, then a home equity loan could be a good fit, as long as you can handle making the full payments along with your first mortgage. On the other hand, if you don't need the money right away but want the convenience of withdrawing some cash as you need it, then a HELOC can work as long as you're comfortable with a variable interest rate and the potential additional fees.

To get an estimate of how much you may be able to borrow using your home's equity and what your payments could look like, you can consult an online comparison calculator like the one Bankrate offers. This will allow you to compare both equity-based lending options and determine which one best fits your budget and needs.

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