Comparing Home Equity Loans Versus Lines of Credit
Building equity is one of the primary benefits of homeownership. Over time, your property can increase your wealth, but that money is only available when you sell or borrow against your home. When it comes to borrowing, you have several options, including a home equity loan and a home equity line of credit (HELOC). Each type of loan has pros and cons, so it’s essential to choose wisely.
HELOC vs. Home Equity Loan
We’ll drill down into the details below, but the fundamental differences include:
- A HELOC is typically a variable-rate line of credit that allows you to borrow and repay repeatedly.
- A home equity line of credit is a one-time loan that you repay with fixed payments over a certain number of years.
In some ways, home equity loans and HELOCs are similar:
- Second mortgages: Both loans are often second mortgages that you can use in addition to an existing home-purchase loan.
- Home equity: You borrow against the equity in your home, which is the value of your home that you actually own after accounting for any mortgage loan balance.
- Secured by your home: Both loans use your home as collateral. If you stop making payments, your lender can potentially force you out of your home through foreclosure. Putting your home on the line is risky, especially if you use the loan for expenses that don’t improve the home’s value.
HELOCs Offer Flexible Borrowing
A HELOC provides a pool of money that you can draw from as needed. Your lender sets a maximum borrowing limit, and you can use as much or as little as you need, similar to a credit card.
Spending: HELOCs typically feature a ten-year “draw period” during which you can borrow multiple times. To access the funds, you can often write checks, use a payment card that’s linked to your loan, or transfer funds to your checking account.
Payments: During the draw period, you may have the option to make small, interest-only payments on your debt. Eventually, you enter a repayment period where your payments go toward both principal and interest. Once you start the repayment period, you can no longer borrow.
Interest rate: HELOCs have variable interest rates, and should start with lower interest rates than home equity lines of credit. But if rates rise, your borrowing costs can increase.
Interest costs: You can minimize interest costs by keeping a small balance (or zero balance) on your HELOC—only borrow when you need money. Contrast this with home equity loans, which charge interest on the entire amount of your loan starting in the first month.
Home Equity Loans Are Predictable
A home equity loan gives you a lump sum. You and your lender agree on an amount, and you receive the entire amount in one transaction.
Spending: Because you receive everything at once, a home equity loan can provide funding for large expenses. If you’re paying multiple expenses or paying over time you can keep any excess amount in your checking account, and spend as needed.
Payments: You repay most home equity loans with fixed monthly payments. Your payment amount and interest rate typically don’t change over time. Instead, your bank calculates a repayment schedule that includes both your interest costs and loan repayment in every monthly payment.
Interest rate: The interest rate is typically fixed, helping to provide predictable, level monthly payments.
Interest costs: You pay interest on your entire loan balance, and your interest costs are highest at the beginning of your loan. To see how the math works, learn about loan amortization. You can minimize interest costs by paying off your loan early, assuming there are no prepayment penalties.
How Much Can You Borrow?
Lenders limit how much you can borrow with both home equity loans and HELOCs. In most cases, you can borrow up to 85 percent of your home’s value—including any existing debt on the property. Some lenders allow you to borrow more, but interest rates and costs rise as you borrow more. For the best terms, keep your loan-to-value (LTV) ratio below 80 percent.
Example: Your home is worth $300,000, and you owe $100,000 on your original purchase mortgage. How much is available for a second mortgage (assuming you have sufficient income and credit scores to qualify)?
- Home value: $300,000
- Existing mortgage debt: $100,000
- Maximum debt amount, assuming 80 percent LTV: $240,000 (multiply 0.80 by $300,000)
- Amount available to borrow: $140,000 (subtract the existing debt of $100,000 from the 80 percent maximum of $240,000)
HELOC Versus Home Equity Loan: Which Is Best?
These loans work differently, and it makes sense to tailor your borrowing to fit your needs.
For flexibility: A HELOC allows you to borrow and repay numerous times over a ten-year period. Getting money is as easy as writing a check or swiping a payment card—you don’t need to apply every time you need more funding. Pay off the balance when you’re able to do so, and borrow again if needed.
For predictability: A home equity loan works when you know exactly how much you need and you want predictability when it comes to repayment. Your monthly payments won’t rise if rates increase, and you don’t need to worry about your lender freezing your credit line or cutting your credit limit.
To minimize interest: With HELOCs, you only pay interest if you borrow money. You can open a line of credit and decide not to use it if you want.
Consolidating debt? Consolidating loans like credit cards and auto loans can be risky when you use home equity. By pledging your house as collateral, you may turn unsecured loans into secured debt. But a home equity loan can convert high-interest-rate debts to a low, fixed rate. The resulting savings may be significant—but make sure you don’t go back into debt. A home equity loan gives you only one chance to borrow, making it slightly safer than a HELOC.