Home Equity Loan vs. HELOC: An Overview
Home equity loans and home equity lines of credit (HELOCs) are loans that are secured by a borrower's home. A borrower can take out an equity loan or credit line if they have equity in their home. Equity is the difference between what is owed on the mortgage loan and the home's current market value. In other words, if a borrower has paid down their mortgage loan to the point where the value of the home exceeds the outstanding loan balance, the borrower can borrow a percentage of that difference or equity.
Home equity loans give the borrower a lump sum upfront for which to spend, and in return, they must make fixed payments over the life of the loan. Home equity loans also have a fixed interest rate. Conversely, home equity lines of credit (HELOC) are credit lines that allow a borrower to tap into as needed up to a certain preset credit limit. HELOCs have a variable interest rate, and the payments are not usually fixed.
Both home equity loans and equity lines of credit allow consumers to gain access to funds that can be used for various purposes, including consolidating debt and making home improvements. However, there are distinct differences between home equity loans and equity lines of credit.
- Home equity loans and home equity lines of credit are different types of loans based on a borrower's equity in their home.
- Home equity loans come with fixed payments and a fixed interest rate for the term of the loan.
- HELOCs are revolving credit lines that come with variable interest rates and, as a result, variable minimum payment amounts.
- The draw periods of HELOCs allow borrowers to withdraw funds from their credit lines, as long as they make interest payments.
Home Equity Loan
A home equity loan is a fixed-term loan granted by a lender to a borrower based on the equity in their home. Home equity loans are often referred to as second mortgages. Borrowers apply for a set amount that they need, and if approved, receive that amount in a lump sum upfront. The home equity loan has a fixed interest rate and schedule of fixed payments for the term of the loan. A home equity loan is also called a home equity installment loan or equity loan.
Loan Collateral and Terms
The equity in your home is used as collateral, which is why it's called a second mortgage and works similarly to a conventional fixed-rate mortgage. However, there needs to be enough equity in the home, meaning the first mortgage needs to be paid down by enough to be qualified to borrow via a home equity loan.
The loan amount is based on several factors, including the combined loan-to-value ratio, or (CLTV) ratio. Typically, the loan amount can be 80% to 90% of the property's appraised value. Other factors that go into the lender's credit decision include whether the borrower has a good credit history, meaning they haven't been past due on their payments for other credit products, including the first mortgage loan. Lenders may check a borrower's credit score, which is a numerical representation of a borrower's creditworthiness.
Payments and Interest Rate
A home equity loan's interest rate is fixed, meaning the rate doesn't change over the years. Also, the payments are fixed, equal amounts over the life of the loan. A portion of each payment goes to interest and the principal amount of the loan. Typically, the term of an equity loan term can be anywhere from five to 30 years, but the length of the term must be approved by the lender. Whatever the period, borrowers will have stable, predictable monthly payments for the life of the equity loan.
Advantages and Disadvantages of Home Equity Loans
A home equity loan can be a good way to convert the equity you’ve built up in your home into cash, especially if you invest that cash in home renovations that increase the value of your home. Although not always, the interest rates for home equity loans are usually lower than other credit products, such as personal loans and credit cards.
Another benefit to home equity loans is that you can pay off the loan early and refinance the loan at a lower rate. A refinancing is merely taking out a new loan, presumably at a lower interest rate than the existing loan, and using the funds to pay off the higher-rate loan. By refinancing at a lower rate, you can save on the monthly payment and pay off the loan sooner. However, borrowers would need to go through the credit approval process again, and there may be fees for booking the new loan.
A disadvantage of home equity loans is that the home could be sold to satisfy the remaining debt if the loan is not paid off or goes into default or nonpayment. As a result, borrowers must be sure not to get overextended and borrow more than they can afford to pay back. If the loan goes into default, the bank may foreclose on or take back the home to satisfy the debt.
Also, if real estate values decrease, the market value of your house could decline, and you could end up owing more than your home is worth. Should you want to relocate, and the home decreases in value, you might end up losing money on the sale of the home or be unable to move.
Home Equity Line of Credit (HELOC)
A home equity line of credit (HELOC) is a revolving credit line. A HELOC allows the borrower to take out money against the credit line up to a preset limit, make payments, and then take money out again.
With a home equity loan, the borrower receives the loan proceeds all at once, while a HELOC allows a borrower to tap into the line as needed. The line of credit remains open until its term ends. Since the amount borrowed can change, the borrower's minimum payments can also change, depending on the credit line's usage.
Loan Collateral and Terms
Like an equity loan, home equity lines of credit are secured by the equity in your home. Although a HELOC shares similar characteristics to a credit card since both are revolving credit lines, a HELOC is secured by an asset (your house) while credit cards are unsecured. In other words, if you stop paying your payments on the HELOC—called default—you could lose your home.
A HELOC has a variable interest rate, meaning the rate can increase or decrease over the years. As a result, the minimum payment can increase as rates rise. However, some lenders offer a fixed rate of interest for home equity lines of credit. Also, the rate offered by the lender—just as with a home equity loan—depends on your creditworthiness and the amount you're borrowing.
Draw and Repayment Periods
HELOC terms have two parts. The first is a draw period, while the second is a repayment period. The draw period, during which you can withdraw funds, might last 10 years, and the repayment period might last another 20 years, making the HELOC a 30-year loan. Once the draw period ends, you cannot borrow any more money.
During the HELOC’s draw period, you still have to make payments, which are typically interest-only. As a result, the payments during the draw period tend to be small. However, the payments become substantially higher in the repayment period since the principal amount borrowed is now included in the payment schedule along with interest.
It's important to note the transition from interest-only payments to full, principal-and-interest payments can be quite a shock, and borrowers need to budget for those increased monthly payments.
Payments must be made on a HELOC during its draw period, which usually amounts to just the interest.
Advantages and Disadvantages of Home Equity Lines of Credit
With a HELOC, you know that the maximum you can potentially borrow, which is the amount of the credit limit. Also, HELOCs offer flexibility to borrow as much or as little as you need up to the credit limit.
However, a disadvantage to HELOCs is that the interest rate can rise, and so too, the payments as a result. This uncertainty can make it difficult to determine the overall cost of a HELOC.
However, if a HELOC has been borrowed from, the amount outstanding can be refinanced into a fixed-rate home equity loan. The lender would issue the new loan and use the proceeds to pay off the HELOC—in which the credit line would be closed. The borrower would pay back the funds under the home equity loan. Of course, the borrower would need to go through the credit approval process to swap the HELOC balance into a fixed-rate equity loan, and there's no guarantee of approval.
HELOCs can be useful as a home improvement loan since they allow you the flexibility to borrow as much or as little as you need. If it turns out that you need more money, you can get it from your line of credit-assuming there's still availability—without having to re-apply for another mortgage loan.
One question you should ask yourself: What's the purpose of the loan? A home equity loan is a good choice if you know exactly how much you need to borrow and how the money will be used. Once approved, you’re guaranteed a certain amount, which you receive in full when the loan is advanced. , as a result, home equity loans can help with big expenses such as paying for a children's college fund, remodeling, or debt consolidation.
Conversely, a HELOC is a good choice if you aren’t sure how much you’ll need to borrow or when you need it. Generally, it gives you ongoing access to cash for a set period—sometimes up to 10 years. You can borrow against your line, repay it all or in part, and then borrow that money again later, as long as you’re still in the HELOC's draw period.
However, an equity line of credit is revocable—just like a credit card. If your financial situation worsens or your home’s market value declines, your lender could decide to lower your credit line or close it altogether. So while the idea behind a HELOC is that you can draw upon the funds as you need them, your ability to access that money isn’t a sure thing.
It's important to note that obtaining a HELOC may be tougher in 2021: In 2020, two major banks, Wells Fargo and JPMorgan Chase put a freeze on new HELOCs as a consequence of the coronavirus pandemic. Other banks could put a lock on credit in the future.
Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).
There was initially some confusion about whether homeowners would be able to deduct the interest from their home equity loans and HELOCs on their tax returns following the passing of the Tax Cuts and Jobs Act. Unlike before the law, homeowners can't deduct interest for home equity loans and HELOCs unless the funds are used to "buy, build, or substantially improve" your home, and the money you spend on such improvements must be spent on the property used as equity for the loan.
In other words, you can no longer deduct interest from these loans if you use the money to pay for your child's college or to eliminate debt. The law applies to tax years through 2025. Deductions are limited to the interest on qualified loans of $750,000 or less ($375,000 for someone who is married filing separately). There are additional rules, especially if you also have a first mortgage, so be sure to check with a tax expert before using this deduction.
The Bottom Line
Keep in mind that just because you can borrow against your home’s equity doesn’t mean you should. But if you need to, there are many factors to consider when deciding which is the best way to borrow: how you will use the money, what might happen to interest rates, your long-term financial plans, and your tolerance for risk and fluctuating rates.
Some people aren’t comfortable with the HELOC’s variable interest rate and prefer the home equity loan for the stability and predictability of fixed payments and knowing how much they owe.
However, if you're uncertain about the amount needed and you're comfortable with the variable interest rate, a HELOC might be your best bet. As with any credit product, it's important not to get overextended and borrow more than you can pay back since your home is the collateral for the loan.