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

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If house values are rising in your neighborhood, you may consider using a home equity loan versus a home equity line of credit (HELOC) to tap some of your growing home equity. Knowing the ins and outs of both products will help you choose the right type of home equity financing for home improvement projects or other financial goals.

Home equity loan vs. a home equity line of credit: How they work

Homeowners sometimes use the terms home equity loan and home equity line of credit interchangeably, but they are very different from each other.

What is a home equity loan?

Home equity loans are typically fixed-rate loans that provide cash in a lump sum and have a set repayment period that ranges 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.

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

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 reuse the line for a set time frame called a “draw period.” After the draw period ends, you must pay the remaining balance in full or on a fixed-installment schedule.

THINGS TO KNOW

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

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 0.85 (maximum loan amount) = $212,500 (maximum combined loan amount)

$212,500 – $175,000 (current loan balance) = $37,500 (home equity loan or HELOC amount)

Home equity loan vs. a home equity line of credit: The differences

Difference between a home equity loan vs. a HELOC
Home equity loan HELOC
You receive a lump sum payment all at once You access funds as needed
You’ll typically have a fixed rate You’ll typically have a variable rate
Your payment is based on the full amount of the loan Your payment is only based on the amount you use
Your monthly payment requires equal payments over the term of the loan You may be able to make interest-only payments during the draw period
Your payment is the same until the balance is paid off Your payment could change when the draw period ends
You’ll pay closing costs once when you close You may have ongoing costs in addition to closing costs
You won’t be charged a fee for paying off and closing the loan out You may pay a fee to pay off and close out the line of credit

Home equity loan vs. a HELOC: The similarities

Despite the big differences between home equity loans and HELOCs, they also have several similar features:

  1. You’ll qualify based on your income, assets, credit and home equity
  2. The loan is secured against your home
  3. You could lose your home if you can’t make payments and the lender forecloses
  4. You’ll have two monthly payments (if you currently have a first mortgage)
  5. You’ll pay closing costs of 2% to 5% of the loan or line amount
  6. You’ll can tap up to 85% of your home’s value in most cases
  7. The interest is tax-deductible if you used it toward buying or improving a home

 

THINGS YOU SHOULD KNOW

A loan-to-value (LTV) ratio is expressed as a percentage and measures how much your loan amount is compared to your home’s value. You may hear the term “combined-loan-to-value” (CLTV) ratio when your loan officer discusses a home equity loan product. This simply “combines” the LTV of your current mortgage with the home equity loan or HELOC balance.

For example, if you have a current balance of $150,000 on your first mortgage, and take out a home equity loan for $75,000 on a home worth $300,000 you would:

  • Have an LTV ratio of 50% ($150,000 divided by $300,000 = 50%)
  • Have a CLTV ratio of  75% ($150,000 + $75,000 = $225,000 divided by $300,000 = 75%)

Pros and cons of home equity loans

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

Pros and cons of  HELOCs

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

 

THINGS YOU SHOULD KNOW

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.

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

A home equity loan makes sense if:

  • You’re making a major renovation to improve your home’s value, such as:
    • Major kitchen remodel
    • Finishing a basement
    • Room addition
  • You’re consolidating or paying off high-interest, long-term debt
  • You have one-time financial needs such as higher education expenses or business start-ups

A home equity line of credit makes sense if:

  • You’re making smaller home improvements spread out over time such as:
    • New appliances
    • HVAC or another system upgrade
    • New flooring
  • You need to cover an unexpected expense like a medical bill or car repair
  • You need a financial cushion for sudden drops in commission or self-employed income
  • You have ongoing financial or investment needs like:
    • Buying and fixing up an investment property to flip
    • Side hustles that require inventory purchases to process orders

THINGS YOU SHOULD KNOW

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 so you can avoid repeating the cycle.

 

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