Money Research Collective’s editorial team solely created this content. Opinions are their own, but compensation and in-depth research determine where and how companies may appear. Many featured companies advertise with us. How we make money.
HELOC vs Home Equity Loan: Which Is Better?
By Jamela Adam MONEY RESEARCH COLLECTIVE
Perhaps the biggest perk of homeownership — apart from having a place to call your own — is the ability to build home equity and tap into it when needed. Home equity is the portion of your home’s value that you own. It grows as you pay down your mortgage or when your home’s value appreciates.
If you want to tap into the equity you’ve built in your home without listing your property for sale or refinancing your mortgage, there are two options: a HELOC or a home equity loan. Both loan types use your home as collateral, but they work slightly differently. This article will discuss each option’s pros and cons and help you make the most informed decision.
What is a home equity loan?
A home equity loan — also known as an equity loan or a second mortgage — is a type of consumer debt that uses your home equity as collateral. Because home equity loans are secured by your home, they typically offer lower interest rates than the unsecured debt that credit cards and personal loans entail. However, if you default on the loan, the lender can foreclose on your property. So be sure you’re comfortable with the risks before taking out a home equity loan.
The amount you can borrow with a home equity loan depends on your home’s appraised value. Generally, second mortgage lenders like to see a combined loan-to-value (CLTV) ratio of less than 85%. You can calculate your CLTV ratio by adding your total loan balances (including your desired home equity loan amount) and dividing that number by your home’s appraised value. For example, let’s say you currently have a mortgage balance of $160,000 and would like to take out a $50,000 home equity loan. If your home appraises for $300,000, your CLTV would be 70%, which is an acceptable percentage.
Once approved for a home equity loan, you’ll receive a lump sum of cash upfront, which you repay with fixed monthly payments over a set period of time (anywhere from 5 to 30 years). Similar to traditional home loans, these fixed payments will cover both the principal and interest. And if you were to default on the loan, the lender can sell your home to recoup its losses.
Applying for a home equity loan can be a great way to get the money you need to cover a big-ticket item. But before submitting your application, make sure you meet the qualifications. Here are some of them:
- Have at least 15% to 20% equity in your home
- A debt-to-income ratio of 43% or less
- A credit score of at least 600
- Verifiable income history of 2 or more years
Pros and cons of home equity loans
As with any type of debt, you should carefully consider the pros and cons of home equity loans before moving forward with the application process.
Pros of home equity loans
- Fixed interest rate
Home equity loans usually have fixed interest rates, which means your monthly payment will stay the same whether the stock market crashes or rates go up. And because you know the exact amount of your monthly payments, you can budget better and keep your finances on track. - Potential tax deductions
According to the IRS, if you use your home equity loan to finance a home improvement project, you could potentially deduct the interest payments on your tax return. - Low borrowing cost
Because your home equity serves as security for the loan, lenders are willing to offer lower interest rates than they would for unsecured loans such as credit cards or personal loans. A lower rate could save you thousands of dollars in the long run if you’re borrowing a large amount of cash.
Cons of home equity loans
- Risk of being ‘underwater’
The value of your home can fluctuate depending on housing market conditions or the state of the economy. If the real estate market crashes or your home is appraised for less than you owe, you could end up ‘underwater’ on your loan — owing more than your home is worth. - Closing costs
Most home equity loans charge closing costs of 2% to 5% of the total loan amount. If you’re taking out a large sum of money, expect to shell out hundreds or thousands of dollars in fees. - You can lose your property
Perhaps the biggest con of taking out a home equity loan is that you could lose your home if you default on the loan. Before signing on the dotted line, make sure you’re confident in your ability to repay the loan. Otherwise, you could end up losing one of your most valuable assets.
What is a home equity line of credit (HELOC)?
A home equity line of credit, or HELOC for short, functions like a credit card tied to your home’s equity. Unlike a home equity loan that allows you to receive a lump sum payment upfront, a HELOC lets you draw on the line of credit as needed, up to the limit set by the lender.
Keep in mind that the interest rate on a HELOC is usually variable, which means it can go up or down over time. So before committing, make sure you understand how the interest rate could change and how that might affect your budget.
You can use your HELOC loan amount for any purpose, and you only have to pay interest on the amount you withdraw during the draw period. The draw period is typically ten years, after which the repayment period kicks in. During the repayment period — which can last up to 20 years — you can’t withdraw any more money, and you’ll need to repay both the principal and the interest on the loan.
HELOCs have similar requirements to home equity loans. To qualify, you must have enough equity in your home, good credit, sufficient income, etc.
Pros and cons of HELOC
A HELOC is a convenient way to tap into your home’s equity. But before taking the plunge and withdrawing money from your line of credit, don’t forget to consider its pros and cons.
Pros of HELOC
- Only pay what you spend
The best part about HELOCs is that you only pay back what you spend. If your HELOC limit is $10,000, but you use only $5,000, then that’s all you’ll have to pay back (plus interest). This flexibility makes HELOCs an attractive option for people planning a significant home renovation but isn’t sure how much the project will ultimately cost. - Introductory rates
You can find some great introductory rates for HELOCs if you shop around. Some lenders offer rates as low as 0.99% for the first few months. If you’re borrowing a big chunk of change, this introductory rate can save you a great deal of money in interest charges. - Access to a large amount of cash
Compared to credit cards and personal loans, HELOCs allow you to access more cash at a lower interest rate, which reduces your overall borrowing costs and makes it easier to finance major purchases.
Cons of HELOC
- There’s a set draw period
Generally, the draw period of a HELOC is ten years. Once the draw period ends, your HELOC will transition into the repayment period (typically 20 years). You won’t be allowed to withdraw any more money during this time, and your monthly payments will now include both the interest and principal amount. - Variable interest rates
Because a HELOC is a variable rate loan, your monthly payment could go up if rates increase. So be careful not to bite off more than you can chew. - Longer application process than credit cards
Since HELOCs offer large loan amounts, the application process is often longer and stricter than it is for credit cards, which can be frustrating for those in a hurry to access the funds they need.
How does home equity work?
Home equity is the portion of your home’s value that you own outright and is not encumbered by mortgage debt. To calculate the untapped cash in your home, subtract your outstanding mortgage balance from the property’s appraised value. Suppose you still owe $125,000 on the house, and your home is worth $200,000. Subtract $125,000 from $200,000 and you’ll end up with $75,000 in home equity. To qualify for a home equity loan or HELOC, lenders typically require you to have at least 15% to 20% equity in the home. In this case, at least $30,000 to $40,000.
What’s the main difference between a home equity loan and a home equity line of credit?
Here’s the main difference between a home equity loan and a HELOC. A home equity loan provides you with a lump sum of cash that you repay in fixed monthly installments over the life of the loan, usually 5 to 30 years. A HELOC, on the other hand, functions more like a credit card — you’re approved for a certain amount of credit that you can draw on as needed, up to a maximum limit. And you’re only charged (variable) interest on the amount you borrow.
Which one should you get?
Whether a home equity loan or a HELOC makes more financial sense will depend on your situation and how you intend to use the loan.
HELOC is better if:
You need money for an ongoing project but aren’t sure how much the total cost would be. By taking out a HELOC, you can access the cash you need — when you need it. This way, if your project costs less than you thought, you’ll only pay interest on the amount of money you withdrew, not the entire credit line.
Home Equity Loan is better if:
You need to borrow a large sum of money upfront to cover a considerable expense, like college tuition or medical bills. Or, you want the security of a set interest rate and fixed monthly payments.
HELOC vs. Home Equity Loan FAQs
How to qualify for a home equity loan or HELOC?
Each lender has slightly different requirements, but generally, you'll need a good credit score and a steady income. You'll also need to have enough equity in your home — most lenders will require that you have at least 15% to 20% equity in your home before they approve a loan or line of credit. So, if you're considering taking out a home equity loan or HELOC, make sure you understand the qualifications before filling out the application.
How do you get home equity?
There are two ways to build equity in your home. You can make payments on your mortgage loan, which gradually reduces the loan balance and increases the portion of your property's value that you own outright. Or you can increase the overall value of your home through remodeling or other home improvement projects. Your home equity will also increase without you doing anything if the market price of your home appreciates.
How to calculate your home equity?
Home equity is the portion of your home's value that belongs to you rather than being tied up in a mortgage. To calculate your home equity, subtract the amount of your outstanding mortgage from the current market value of your property.
Note that your home equity can be at risk if your property value declines. So be sure to monitor your home's market value and stay up-to-date on any changes in your mortgage balance.
What is the interest rate on a HELOC?
Your interest rate on a HELOC can vary depending on factors like your credit score, combined loan-to-value ratio, your lender, etc. At the U.S. Bank, for example, if you have a FICO score of 730 or higher and a credit limit of $100,000, you can expect a variable APR of around 5.70% (assuming 70% CLTV) as of this writing. But this interest rate can go up to over 10% if you have a less-than-ideal credit score and a high CLTV.
What is the interest rate on a home equity loan?
Like HELOCs, the interest rate on a home equity loan will depend on the lender, your creditworthiness, and other factors such as the loan amount. For example, at present, U.S. Bank offers a fixed interest rate of 6.10% if you have a FICO score of 730 or higher, a CLTV of 70%, and take out a 10-year loan amount between $50,000 and $100,000. But if you go with another bank, your interest rate could be significantly higher or lower. What's more, interest rates fluctuate. So be sure to do your homework and compare rates from different lenders before you commit to a loan.
Summary of our guide to HELOC vs. Home Equity Loan
What’s the verdict? HELOCs or home equity loans? Ultimately, it comes down to your preference and financial situation. A HELOC might be the better option if you need flexibility in using the money. But if you prefer the peace of mind associated with fixed monthly payments, a home equity loan might be better suited to your needs.
Whichever option you choose, make sure you understand the structure and terms of your loan and the potential consequences of default. Make sure you’re comfortable with the agreement and that you can afford to make your payments on time every month.
