two houses looking at differences between HELOC and Home Equity Line of Credit

Home Equity Loan vs. HELOC: What’s The Difference?

tl;dr

What You Need To Know

  • Home equity loans and home equity lines of credit (HELOCs) let you borrow against the equity in your home
  • A home equity loan gives you a lump sum of money. A HELOC uses revolving credit – like a credit card
  • The primary reasons to use them are to pay for home improvements and consolidate debt

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If you’re a homeowner and need money, one of the most affordable ways to get it is to borrow against your home’s equity.

While there are different options available, like a cash-out refinance, the two most common options to access your home’s equity are a:

  • Home equity loan
  • Home equity line of credit (HELOC)

Let’s see how they compare in this legendary matchup for equity disbursement dominance.

Home Equity Loan vs. HELOC: The Battle of the Loans 🔔🔔🔔

Tonight’s title fight pits two home equity powerhouses against each other in the ultimate throwdown to decide the best way to tap into the value of your home.

In the red corner, you have: the reliable standby, the fixed-rate fighting machine, the consistent monthly payment pugilist, the lump sum leviathan, the second mortgage or home equity installment loan. Give it up for the home equity loan!

And, in the blue corner, you have: the revolving credit wrestler, the adjustable-rate assailant, the pay-as-you-go pummeler. Popularly known as the HELOC, it’s the home equity line of credit!

Let’s get ready to rumble …

Home Equity Loan vs. HELOC: How Are They the Same?

Fight night theatrics aside, the two methods of accessing your home’s equity are pretty evenly matched.

Here are the similarities:

Require home equity: The power

To qualify, you should have at least 15% – 20% equity in your home. The amount you can borrow will be based on your combined loan-to-value ratio (CLTV).

CLTV = Amount you owe on your mortgage + the amount you want to borrow / value of your home

Lenders usually prefer that your CLTV doesn’t exceed 80% – 85% of the value of your home.

Interest rates: The reach

Home equity loans and HELOCs have interest rates similar to, but usually higher than, a conventional mortgage loan. That’s because there’s more risk assumed with a second mortgage.

Like a mortgage, your interest rate will be based on a review of your employment and credit history, credit score and debt-to-income (DTI) ratio. While lenders usually prefer a DTI of 36% or lower, they may be willing to consider a DTI as high as 50%.

Starting interest rates usually range from 3% – 8%. If interest rates are low, a HELOC may have a lower rate to start, but remember, HELOCs have variable interest rates. That means the interest rate may change throughout the life of the loan. That can change depending on whether the Federal Reserve raises or lowers interest rates and whether the housing market is hot or cold.

Application process: The speed

The application process for both loans can range from 2 – 6 weeks but expect a minimum of a month from application to final approval.

Your home is the collateral: The title

Interest rates for a home equity loan or HELOC are lower than the interest rates for an unsecured loan (like a credit card or personal loan) because your home serves as the collateral. If you miss payments, you can lose your home.

Tax-deductible (sorta): The wild card

Back in the day, the interest on home equity loans and home equity lines of credit was tax-deductible.

The Tax Cuts and Jobs Act of 2017 changed the rules and limited the tax break. Now, it only applies to money borrowed to buy, build or restore a home.

In other words, if you borrow money to pay off your credit cards or finance a wedding, the tax deduction won’t apply.

Home Equity Loan vs. HELOC: How Are They Different?

We know how the loans compare. Now, let’s see how they differ.

Home Equity LoanHome Equity Line of Credit
What is the key benefit?Predictable paymentsGreater flexibility. You pay no interest on money you don’t use
How is the money distributed?One lump sumRevolving credit
 
Similar to a credit card with a credit limit

As long as you pay down your debt and don’t exceed your limit, you can draw as much as you’d like

Money is available for withdrawal using a debit card or check
How long do I have to repay my loan?Loan amount repaid through a fixed monthly payment over a 5-, 10- or 20-year termLoan divided into two periods that equal up to 30 years

Draw period: Up to 10 years. Only interest payments required

Repayment period: Up to 20 years. Must pay down existing balance
Are my interest rates fixed or adjustable?Fixed interest rateAdjustable or variable interest rate

Some options available to convert to a fixed rate for a set period of time
Can I buy points to lower my interest rate?YesNo
Are there closing costs?Usually 2% – 5% of loan valueVaries by lender. Tend to be lower than home equity loan costs
Are there annual fees?NoYes
What are the best uses?Large home improvement or renovation projects that require a large sum of money upfront

Debt consolidation

Invest in second home or investment property
Home improvement and renovations requiring smaller payments over time to multiple vendors

Pay off debt or use as an alternative to credit card debt

Emergency fund

Cover expenses in retirement

Home Equity Loan vs. HELOC: What Are the Risks?

Home equity loans and HELOCs carry similar risks.

Avoid the rope-a-dope: Adding to personal debt

A home equity loan can be a great way to consolidate and pay off personal debt. But this only works if you have your debt under control. If you borrow against your home and continue to rack up more credit card debt, you may get caught up against the ropes.

When you get trapped with too much debt, you run the risk of losing your home.

Welcome to Margaritaville: Avoid temptation

In a “South Park” episode, Randy Marsh angrily – and terribly – explains the 2008 financial crisis while mixing up tropical drinks with his new margarita machine that was probably bought using home equity.

While the quiet Colorado mountain town is known for taking things to the extreme, there is a real risk when you have a lump sum of cash in your bank account or on a debit card connected to your HELOC. It can be hard not to spend the money on frivolous things or things you really want, like a new car or a vacation.

That’s why it’s a good idea to know why you’re borrowing. Set personal limits on when and how you use your home equity.

What goes up can go down: Be wary of falling home prices

When you take out a home equity loan or HELOC, the amount you borrow is based on the current value of your home. But what if your home value drops?

If you’re able to make all of your payments, you should be OK. But if you fall behind, you risk losing your home and owing money. If your home value drops enough, you could be underwater on your mortgage, meaning you owe more on your loan than your home is worth.

It’s the Final Countdown: Who Won?

The truth is, home equity loans and HELOCs have their distinct advantages. Your decision should be based on how you want to use your available equity. If you’re looking for help, talk to your lender about the best options for you.

#icymi

In Case You Missed It

Take-aways

  1. Home equity loans have fixed interest rates, making them more predictable. HELOCs offer variable interest rates and greater flexibility
  2. Home equity loans and HELOCs both offer lower interest rates than some commercial loans
  3. Because your home equity loan or HELOC is tied to your home’s value, you may be in trouble if home prices start to drop

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