HELOC vs. home equity loan: What to know
Updated 7:32 AM EDT, Thu May 16, 2024
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Your home equity – that is, the amount of your home that you own outright – can be a major source of cash. There are two options for tapping it: home equity lines of credit (HELOCs) and home equity loans.
Thanks to the steady appreciation of home values in recent years, mortgage holders were sitting on $10.5 trillion in tappable equity in mid-2023, according to real estate data firm Black Knight.
Homeowners’ ability to secure these loans have coincided with a growing appetite for them. The number of originated HELOCs and home equity loans increased by 50% in 2022 compared to two years earlier, according to the Mortgage Bankers Association. Home renovations largely drove the demand, followed by debt consolidation and emergency cash needs (all of which were, in part, driven by the COVID-19 pandemic).
Like all financial products, these have unique advantages and drawbacks, such as their variable rates (true of HELOCs) or fixed repayment (home equity loans). Here’s a look at their similarities and differences as well as tips on deciding which is right for you.
What are HELOCs and home equity loans?
A home equity line of credit is a form of revolving debt and works somewhat like a credit card and typically has a variable interest rate. A lender approves you for a certain amount of credit for a “draw period,” when you can borrow as much as you need (up to your credit limit) by writing a check or using a debit card connected to the account.
Like a credit card, you can borrow, repay and borrow again. But unlike the plastic in your wallet, a HELOC draws on your home’s equity, which increases the amount you owe.
During the draw period, which commonly lasts five to 10 years, you only pay interest on the amount you borrow. Once the draw period expires, you transition into a repayment period, most often 20 years.
A home equity loan is a secured installment loan because it comes in a lump sum and carries a fixed interest rate. It’s also predictable in that you repay the loan in equal monthly payments over a set period.
As with a HELOC, a home equity loan is secured by your home, so failure to repay can result in foreclosure.
Similarities of HELOCs and home equity loans
Lent by banks, credit unions and online lenders, HELOCs and home equity loans are types of so-called second mortgages since they’re secured by your home. You can likely borrow up to 75% to 85% of your home’s equity, which is the appraised value of your house minus your mortgage debt.
For example, if your home is currently worth $400,000 and you owe $200,000 on your mortgage, your home equity is $200,000. You could potentially borrow $150,000 to $170,000 (0.75 or 0.85 x $200,000).
Here are other ways these financing options are similar:
- Since your home serves as collateral, interest rates for both HELOCs and home equity loans are often lower than those on unsecured loans and credit cards.
- Both products have similar eligibility requirements: FICO score of 680 or more, debt-to-income ratio of 43% or less, equity in your home equal to 15% to 20% of the home’s value and proof of homeowners insurance.
- Lenders vary fees for origination, prepayment and annual membership — some financial institutions don’t charge any — so be sure to compare lenders carefully.
- If you default on your loan, your house is at risk of foreclosure in both cases.
- When you tap home equity with either option, you lose equity in your home. If home values decline, you could end up owing more than your home is worth. (This is known as being “underwater” or “upside down” on your home-related debt.)
- You might qualify for a tax deduction on the interest paid on both HELOCs and home equity loans if you use the loan to “buy, build, or substantially improve your home,“ according to the IRS.
HELOCs vs. home equity loans: How they’re different
HELOCs are more flexible than home equity loans since they allow you to tap a line of credit when needed.
“The nice thing about a HELOC is if you have a (home) remodel and then pay it off, you can use (the line of credit) for another expense,” said Matthew Locke, national mortgage sales manager at UMB Bank.
Rates represent another major difference. HELOC rates are usually variable and move in line with the prime rate, while the rate on a home equity loan is fixed for the life of the loan.
| HELOC | Home equity loan | |
|---|---|---|
Rate type
| The interest rate is typically variable, so your monthly payment can fluctuate based on the prime rate, which most lenders use as a benchmark.
| The interest rate is fixed for the term of the loan.
|
Today’s rates
| The average rate ranges between 7% and 10%.
| The average rate ranges between 8% and 10%.
|
Disbursement
| You can draw on the line of credit when you need it.
| You’ll receive a lump sum.
|
Repayment
| Once your draw period ends, you’ll repay the principal, usually over 20 years.
| You’ll repay in fixed installments over five to 30 years.
|
Pros and cons of a HELOC
| Pros | Cons |
|---|---|
|
|
A major advantage of a HELOC is that you only pay interest on the amount you borrow.
“Let’s say you have a $20,000 line of credit but you only use $10,000,” Locke said. “You only pay interest on that $10,000, whereas with a home equity loan of $20,000, you pay interest on the whole amount no matter what.”
Another key feature of HELOCs is their variable interest rate — which can be a pro or a con, depending on the market. When interest rates are dropping, a variable rate is advantageous, but when rates are rising, the amount of interest you pay also rises.
Pros and cons of a home equity loan
| Pros | Cons |
|---|---|
|
|
For some, predictability is the key advantage of a home equity loan since it resembles a conventional loan with straightforward terms. Your rate and payment will be fixed over the life of the loan, and at the end of the term, your loan will be paid off.
“You don’t have to worry about the rate going up on you while you have it outstanding, but on the flip side with the expectations that interest rates (could) start to drop at some point (in 2024), you won’t get that benefit of the rate coming down either,” said Melissa Cohn, an East Coast-based mortgage broker with nearly four decades of experience.
How to choose between a HELOC and home equity loan
Thinking about your borrowing purpose and financial situation should help you choose between a HELOC and home equity loan. But these broad-strokes examples can be a starting point:
| Scenario | Best choice |
|---|---|
You need to borrow a set amount and prefer a straightforward repayment in fixed installments.
| Home equity loan
|
You have a long-term home improvement project with variable expenses.
| HELOC
|
You’ve been tempted in the past to use your available credit (such as with credit cards) on unnecessary expenses.
| Home equity loan
|
You expect interest rates to decline in the coming years and have room in your budget for a fluctuating monthly payment.
| HELOC
|
You want to consolidate high-interest credit card debt and can afford a shorter repayment term.
| Home equity loan
|
How to qualify for home equity financing
Qualifying for a HELOC or home equity loan is similar to qualifying for a first mortgage. You’ll need to meet the following qualifications:
- FICO score of 680 (though some lenders may have a lower minimum)
- Solid payment history
- Proof of income
- Debt-to-income ratio of 43% or less (though higher is sometimes workable)
- Appraisal to officially stamp your home value
- Equity in your home equal to 15% to 20% of the home’s value
- Proof of homeowners insurance
Steps to apply for a HELOC or home equity loan
Applying for a HELOC or home equity loan is similar to applying for a first mortgage. “A lot of institutions may utilize the same application process for both products,” said Locke.
Here are the steps you’ll need to take:
1. Shop around. Compare offers from multiple home equity lenders (or the best HELOC lenders) to get the best possible rate and terms. “Just like looking for a new mortgage, it’s best to shop around a bit because there could be a pretty big difference in fees,” Locke said. Prioritize lenders that allow you to prequalify — or clarify eligibility and check rates without a hard credit check.
2. Gather paperwork. Be prepared to provide proof of income and assets. This may include pay stubs, W-2s and tax returns.
3. Apply. This could be via an online application or paper application at a bank. The lender will pull your credit report, look at your credit history and income and assess your ability to repay the loan.
Frequently asked questions (FAQs)
Yes, provided you meet the lender’s qualifications. But should you take such a large amount of debt? “Legally and technically, you could, but we don’t see it very often,” Locke said. “What we see more often is someone with a regular first mortgage who opts for a home equity loan or home equity line of credit as a second mortgage.”
A big determinant is what you’ll use the loan to pay for and how frequently you’ll need access to funds.
“The first thing you have to determine is whether this is a one-time use or over time,” said Locke. “One-time use might be if you’re going to remodel your kitchen, then maybe you use a home equity loan. But if you’re going to use it for more things, remodel other parts of your house or pay for another large expense, a line of credit might be better.”
Both loans use your home as collateral, so if you fail to repay either loan, your home will be at risk of foreclosure.
With a HELOC, the variable interest rate can be a drawback since it can increase as rates rise.
“Another drawback to a home equity line of credit is that you have interest-only payments for the draw period, and you’re not paying down principal,” Locke said. “That’s a downside to some people.”
With a home equity loan, you’ll pay interest on the entire amount you borrow, and you don’t have the flexibility to use it like a line of credit, tapping it when needed.
One alternative is a cash-out refinance on your first mortgage. That involves taking out a new mortgage that’s larger than your existing one — then pocketing the difference. Cash-out refinancing comes with closing costs, fees, a new interest rate and repayment terms. However, mortgage rates today may be higher than the rate you locked in on your first mortgage, so refinancing could be unwise.
A reverse mortgage is another way to tap home equity for people who are age 62 or older. But reverse mortgages come with their own drawbacks, such as increasing your debt, decreasing your home equity and posing a potentially higher risk of foreclosure.
Editorial Disclaimer: Opinions expressed here are the author's alone, not those of any bank, credit card issuer, airlines, hotel chain, or other commercial entity and have not been reviewed, approved or otherwise endorsed by any of such entities.
This content is for educational purposes only and is not intended and should not be understood to constitute financial, investment, insurance or legal advice. All individuals are encouraged to seek advice from a qualified financial professional before making any financial, insurance or investment decisions.
Note: While the offers mentioned above are accurate at the time of publication, they're subject to change at any time and may have changed or may no longer be available.
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