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Comparing a Home Equity Loan vs. a Home Equity Line of Credit (HELOC)

When values rise in your neighborhood, home equity tends to grow. Using a home equity loan vs. a home equity line of credit (HELOC) may allow you to tap your equity in cash, but each option has pros and cons.

Knowing the advantages and disadvantages of both products will help you choose the right type of financing for home improvement or other financial goals.

What is a home equity line of credit (HELOC)?

A HELOC is a revolving line of credit that works like a credit card — except it’s secured by your home. You can withdraw money as needed up to a maximum limit, pay the balance to zero and re-use the line for a set time frame called a draw period.

After the draw period ends, the remaining balance must be paid in full or on a fixed-installment schedule. Weighing HELOC pros and cons will help you decide if it’s the right choice for you.

Pros and cons of a HELOC

Pros

  • Tap equity as needed and pay off balances without closing the line
  • Option to make interest-only payments
  • Lower interest rates than personal loans or credit cards
  • Interest may be tax-deductible if used for home improvements

Cons

  • Adjustable-rates may result in higher monthly payments
  • Draw period lasts for a limited time only (usually 10 years)
  • May have annual membership and close-out fees
  • After the draw period ends, a balloon payment may be due
  • APR may not reflect the closing costs you pay
  • You could lose your home if you default on the loan

A note about HELOC cost estimates: The annual percentage rate (APR) on a HELOC may not reflect all loan charges. The Consumer Financial Protection Bureau (CFPB) recommends comparing HELOC fees that different lenders charge, rather than APRs, to ensure you’re getting the best deal.

What is a home equity loan?

Home equity loans are typically fixed-rate loans that provide cash in a lump sum for a set repayment period. Home equity loan terms vary but are usually between five and 15 years. Home equity loans are also called “second mortgages,” because they are in the “second” position behind your original home loan.

Pros and cons of a home equity loan

Pros

  • Fixed payment for the life of the loan
  • Lower interest rate than a personal loan or credit cards
  • Interest may be tax-deductible if used for home improvements
  • APR reflects all closing costs

Cons

  • Interest rates are typically higher than a HELOC or a first mortgage
  • Closing costs as high as 2% to 5% of the loan amount
  • You could lose your home if you default

Comparing a home equity line of credit vs. a home equity loan

If you’re trying to decide between a home equity loan vs. a home equity line of credit, the following table provides a side-by-side comparison of each loan type.

Loan Feature HELOC  Home Equity Loan 
Interest rate Interest rate is usually variable
Interest rates are lower than other types of financial products
Interest rate is typically fixed
Interest rates are lower than other types of financial products
How money is disbursed Draw as you need it Receive in one lump sum
Monthly payments Make payments only on what you draw Fixed-rate payment for a set term
How monthly payments are calculated Interest-only payments possible Principal and interest payments
Closing costs 2% to 5% of the total line of credit 2% to 5% of the loan amount
Ongoing costs Annual membership and transaction fees
Early payoff or termination fee
None

 

The biggest difference between a home equity loan and a HELOC is how you access your home equity and how monthly payments are calculated.

Which type of home equity loan is best for you?

A home equity loan is best if you prefer fixed monthly payments and know exactly how much money you need for a financial goal or home improvement project. On the other hand, a HELOC is a better fit for financial needs spread over time, or if you want flexible access to your equity that you can pay off quickly.

A home equity loan is best for … A HELOC is best for …
A major renovation to improve your home’s value, such as:

  • Major kitchen remodel
  • Finishing a basement
  • Room addition
Smaller home improvement projects spread out over time, such as:

  • New appliances
  • HVAC or another system upgrade
  • New flooring
Long-term debt consolidation:

  • Paying off or consolidating high-interest debt
Short-term debt consolidation:

  • Covering an unexpected expense like a medical bill or major car repair
  • Financial cushion during periods of  unexpected drops in commission or self-employed income
One-time financial need:

  • Higher education expenses
  • Starting a business
Ongoing financial or investment needs:

  • Buying and fixing up an investment property to flip
  • Side hustles that require inventory purchases to process orders

 

Typically, you’ll get the most benefit from using a home equity loan or HELOC toward home improvement projects.

If you’re tapping equity to pay off high-interest credit card debt, you’re solving a short-term problem by going deeper into debt for a longer period — and you’re also putting your home at greater risk of foreclosure. Before using home equity to pay down debt or for major expenses, create a plan for how you would repay a home equity loan. More importantly, address the spending habits that caused your debt to balloon to avoid repeating the cycle.

How much equity can you tap?

A home equity calculator can provide a glimpse of how much you can borrow. In most cases, you’re limited to borrowing 85% of your home’s equity, according to the Federal Trade Commission.

For example, if your home is worth $250,000, and your current loan balance is $175,000, you could access $37,500 with a home equity loan or HELOC.

The math is straightforward:

  • $250,000 x .85 maximum loan = $212,500 maximum combined loans
  • $212,500 – $175,000 current loan balance = $37,500 home equity loan or HELOC

The housing crash of 2007-08 is a reminder that home prices can — and do — fall. Use only as much equity as you think you’ll need. Tapping too much equity could mean less cash at the closing table when you sell your home or, even worse, having an underwater mortgage if home prices suddenly drop.

 

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