Home Equity Lines of Credit (HELOCs) and home equity loans are two of the most common ways for homeowners with substantial equity in their homes to get cash-in-hand. A HELOC is a line of credit you can take out at various times at a variable interest rate, while a home equity loan is a fixed-rate loan that’s paid upfront as a lump sum.
But if you’re comparing HELOCs versus home equity loans, which one offers the best deal for you? In this guide, we’ll break down everything you need to know about HELOCs and home equity loans to help you make the best decision to meet your needs.
HELOCs and Home Equity Loans: Compared
On the surface, HELOCs and home equity loans are pretty similar. Both HELOCs and home equity loans enable you to borrow cash against the equity in your home. Additionally, both HELOCs and home equity loans require substantial equity to qualify.
In fact, you’ll likely need at least 15% – 20% equity in your home to be approved for either option. You’ll also need to have good or excellent credit when you apply, especially if you want to qualify for better interest rates.
However, most of the similarities end there.
A HELOC is a secured, rolling line of credit that you can withdraw from at any time. Your lender will set a maximum on the amount you can borrow based on your equity.
Generally, you won’t be able to borrow more than the remaining value of your home. For instance, if you have 80% equity in a home valued at $500,000, you won’t be able to borrow more than 80% of the home’s fair market value, or $400,000.
Interest rates vary between HELOCs and home equity loans. Typically, HELOC interest rates are adjustable, which means your monthly payments could go up or down based on current market interest rates.
That said, you may be able to “lock in” a fixed rate or convert your HELOC to a fixed rate loan – if you’re willing to make some concessions related to the withdrawal terms.
Alternatively, a home equity loan is a secured loan with a fixed interest rate; you get a lump sum upfront and make the same payments for the life of the loan. If your credit improves before the loan has been paid off, you can refinance your home equity loan to get a better interest rate going forward.
HELOC vs home equity loan
|HELOC||Home Equity Loan|
|Pull money out as you need it||✔️|
|Interest-only payment options||✔️|
HELOCs and home equity loans allow you to borrow against your existing home equity to pay for anything you need, from a home renovation to high-interest debt.
While home equity loans offer a lump sum and fixed interest rates, HELOCs give you access to credit that you can take out as needed, usually with a variable interest rate.
How To Calculate Your Home Equity
You might not know if you qualify for home equity products based on your current equity.
Fortunately, it’s relatively easy to calculate how much equity you have in your home and determine your loan-to-value (LTV) ratio. To calculate your home’s equity, subtract the amount you still owe on all home loans from the value of your home (its appraised value).
For instance, say you still owe $600,000 on a home valued at $800,000. This would mean you have $200,000 – or 25% – equity in your home, which would be more than enough to qualify for HELOCs or home equity loans.
However, keep in mind that both loan products take your credit score, income and debt-to-income (DTI) ratio into account when processing your application.
Home Equity Lines of Credit (HELOC)
Home equity lines of credit function much like credit cards. You can borrow up to a maximum amount (your credit limit) based on your particular needs.
However, with HELOCs, you have a set withdrawal period that typically lasts for 5 – 10 years. During this period, you can withdraw funds and make interest-only payments.
After the draw period ends, the repayment period begins and generally lasts for up to 20 years. During this time, anything you owe is converted into a loan consisting of the principal plus interest.
This is a form of revolving credit, meaning you can take out funds as you need them.
You can always choose to borrow funds all at once, but this will require you to pay interest on the amount you take out.
For this reason, HELOCs work better if you’re in a position to borrow smaller amounts as needed. HELOCs are also preferred if you’re making home improvements, as you can get a tax deduction for the interest paid on funds used for this purpose.
When you apply for a home equity line of credit, you’ll need to show that you have substantial equity in your home – usually at least 20%. You’ll also need to provide proof of income that you can make your monthly payments.
Lastly, the lender will run your credit and evaluate your DTI ratio. Generally, you can only qualify for a HELOC with a minimum credit score of 680 and a DTI ratio of no more than 43%
HELOC pros and cons
A HELOC can be a great home equity product if you don’t know exactly how much money you need and want to control how and when funds are withdrawn.
That said, rising interest rates could make it harder to predict future payments and budget accordingly.
With a HELOC, you choose exactly when and how much you borrow (up to your designated credit limit).
Like a credit card, a HELOC gives you the ability to access funds when an emergency arises.
Payments aren’t fixed and will likely increase over time. This makes it more difficult to determine how much you can afford to withdraw.
Interest rates make it harder to predict how much your HELOC will cost. If interest rates increase, you could end up paying more than you expected.
Home Equity Loans
A home equity loan is a secured loan that lets you borrow against the equity you have in your home.
In essence, this type of loan gives you the ability to turn your home equity into liquidity with a lump sum of cash. You can also know exactly how much the loan will cost you with fixed payments and interest rates.
You can use a home equity loan to pay for anything you want or need.
For instance, you can pay for home repairs, improvements and general expenses. Alternatively, if you qualify for a competitive interest rate, it could make fiscal sense to take out the loan and use it to pay off high-interest debt.
The requirements to qualify for a home loan are similar to those required for a HELOC. You’ll need to show proof of sufficient income, substantial equity (usually at least 20%) as well as good or excellent credit and a DTI of no more than 43%.
Home equity loans pros and cons
Home equity loans can be great if you need funds now, but that doesn’t guarantee a home equity loan will be right for you.
With a home equity loan, you get the full loan amount upfront. Assuming you borrow against all of your equity, you’ll receive the full value of your home’s equity in cash.
Home equity loan payments are fixed, meaning the interest rate doesn’t change. This makes it easier to budget your money and know exactly how much you owe.
If your home loses value after you take out your loan, it could cause you to owe more than the principal value of your home – known as an underwater mortgage.
You’ll have at least two loans on your home: your mortgage and your home equity loan. This might make it difficult to make payments on time. Since a home equity loan requires you to use your home as collateral, taking on too much debt could put you at risk of losing your home.
HELOC vs. Home Equity Loan: Which One Is Right for You?
HELOCs offer rolling credit against your home’s equity, which you can use at your discretion. While HELOCs can be relatively low-risk if you only take out what you can afford, the variable interest rates can make it harder to know how much you’ll actually have to pay.
That said, if you want to delay making bigger payments for a while, most HELOCs give you the ability to make interest-only payments during your draw period.
Alternatively, home equity loans give you a lump sum of cash against your home equity. This is better if you need larger sums now, with the benefit of fixed payments and interest rates.
However, since you’ll need to put your home up as collateral, defaulting on a home equity loan could put you at greater risk of losing your home.
Both HELOCs and home equity loans have similar application requirements. So you can generally decide which is best for you based on your financial needs and risk tolerance.
If you can afford unpredictable payments and variable interest rates down the road, a HELOC is likely the better option. On the other hand, if you can afford two loans simultaneously (mortgage and home equity) and want all of the funds now, a home equity loan is probably right for you. It’s also worth considering HELOCs if you anticipate a large tax bill, as the interest on funds used for home upgrades is tax deductible.
Put Your Home’s Equity to Good Use
Whether you want to upgrade your home or pay for your child’s college tuition, home equity products give you the ability to take out funds on terms that work for you. Choosing between a HELOC and a home equity loan will ultimately come down to your specific needs, budget and ability to take on more debt.
The Short Version
- Both HELOCs and home equity loans enable you to borrow cash against the equity in your home
- A HELOC is a secured, rolling line of credit that you can withdraw from at any time
- A home equity loan is a secured loan with a fixed interest rate; you get a lump sum upfront and make the same payments for the life of the loan
Federal Trade Commission. “Home Equity Loans and Home Equity Lines of Credit.” Federal Trade Commission. Retrieved November 2022 from https://consumer.ftc.gov/articles/home-equity-loans-and-home-equity-lines-credit