Do you need a way to pay for a major expense like sending your child to college or renovating your kitchen? Or would you like to eliminate, once and for all, those outstanding credit card balances? The answer might be, literally, in your own backyard. If you have enough equity in your home, you can borrow against it at a fairly low interest rate and – depending on how you use the funds – the interest payments may be tax deductible.
There are two basic ways to use your residence as collateral: a home equity loan and a home equity line of credit (HELOC). Here are the points you should consider when choosing between them.
What's the Money For?
First question: What's the purpose of the loan? A home equity loan, sometimes called a home equity installment loan, is a good choice if you know exactly how much you need to borrow and what you’ll use the money for. You’re guaranteed a certain amount, which you receive in full at closing.
“Home equity loans are generally preferred for larger, more expensive goals such as remodeling, paying for higher education or even debt consolidation since the funds are received in one lump sum,” says Richard Airey, senior mortgage originator at First Financial Mortgage in Portland, Maine. Of course, when applying, there can be some temptation to borrow more than you immediately need, since you only get the payout once, and you don’t know if you’ll qualify for another loan in the future.
Conversely, a HELOC is a good choice if you aren’t sure how much you’ll need to borrow or when. 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 introductory period.
However, a line of credit is revocable. 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. “HELOCs are best used for shorter-term goals, say 12 to 20 months, as the [interest] rate can fluctuate and is generally tied to the prime rate,” Airey says.
Keep in mind, too, that the interest you pay on both HELOCs and home equity loans is only tax deductible if you use the funds 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. It's no longer possible to deduct interest from these loans if you use the money to pay for your child's college or to eliminate debt. There are additional rules, so be sure to check with a tax expert before using this deduction. (See Is the Interest on a Home Equity Line of Credit (HELOC) Tax Deductible?)
Factors of Interest
For years, a major consideration in whether to get a home equity loan or a HELOC was the interest rate. The rates on HELOCs were typically at least a full percentage point lower than the interest rate on home equity loans, so it was tempting to choose the HELOC, even though the rate is variable, while a home equity loan’s rate is fixed (more on that below).
Today, HELOCs are a bit higher than home equity loans, though the difference is negligible. According to Bankrate’s weekly survey of major lenders for April 25, 2018, a home equity loan had an average interest rate of 5.57%, while a HELOC had an average interest rate of 5.90%, a difference of less than half a percent.
However, you need to consider not only the current difference in interest rates, but also where interest rates are headed. If they stay the same or decrease, a HELOC’s lower rate could make sense. But if rates are headed up, a home equity loan might be the way to go. In fact, analysts expect interest rates to increase, so locking in today’s low home equity loan rates could make a lot of sense.
It's also important to consider how each loan is structured. A home equity loan works like a conventional fixed-rate mortgage. You borrow a set amount at a set interest rate and make equal payments for the entire loan term, which can last anywhere from 5 to 30 years. Whatever the period, you’ll have stable, predictable monthly payments for the life of the loan.
In contrast, a HELOC’s loan term has two parts: a draw period and 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 more money.
During the HELOC’s draw period, you do have to make payments, but they tend to be small, often amounting to paying back just the interest. HELOC borrowers at U.S. Bank, for example, pay either interest only or 1% or 2% of the outstanding balance during the draw period. During the repayment period, payments become substantially higher, because you now are paying back principal. During the 20-year repayment period, you must repay all the money you’ve borrowed, plus interest at a variable rate.
That jump in payments at the onset of the new period has resulted in payment shock for many an unprepared HELOC borrower. If the sums are large enough, it can even cause those in financial straits to default. And if they default on the payments, they could lose their homes; remember, that's the collateral for the loan.
The Long View
If you’re the type of person who takes a big-picture view of your financial decisions, a home equity loan might make more sense. Because you’re borrowing a fixed sum at a fixed interest rate, taking out a home equity loan means knowing how much you’ll be paying for the loan in the long run the minute you take it out (though you can reduce that amount if you pay off the loan early or refinance at a lower rate). Borrow $30,000 at 5.5% for 20 years and you can easily calculate that the total borrowing cost, including interest, will be $49,528.
With a HELOC, you know that the maximum you’ll potentially borrow is the amount of your credit limit, but you don’t know how much you’ll actually borrow. You don’t know what interest rate you’ll pay, either. That means it’s difficult to calculate a HELOC’s long-term cost.
Of course, it might also be easy to fit a HELOC into your big picture if you just want to have a line of credit handy, and you don’t plan to use it much. But if you plan to draw on the HELOC heavily and want to know what your net worth might look like in 20 years, that’s much harder to anticipate.
Best of Both Worlds
Can't decide between the two vehicles? Don't fret: There are ways to get some of a home equity loan’s stability with some of a HELOC’s flexibility. Some lenders give borrowers the option of converting a HELOC balance to a fixed-rate loan. U.S. Bank, for example, lets you lock in a fixed interest rate for terms such as 15 or 20 years on all or part of your variable-rate balance. You can have up to three fixed-rate balances at a time. Bank of America and Wells Fargo also offer fixed-rate options on their HELOCs (using them, in fact, to replace home equity loans, which they've stopped offering altogether).
Pentagon Federal Credit Union, the second largest U.S. credit union (which people can join for a small fee and by joining certain organizations) offers another interesting option: a 5/5 HELOC, where the interest rate only changes once every five years.
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 do have the need, 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 knowing exactly how much their payments will be and how much they will owe in total. Home equity loans are much easier to work into a budget, as Airey points out.
In addition, “fixed home equity loans result in less frivolous spending," Airey adds. With a HELOC, “the low, interest-only payments and the easy access can be tempting to those who are not financially disciplined. It can become easy to spend on unnecessary items, just like a credit card,” he says. (See 5 Reasons Not to Use Your Home Equity Line of Credit.) If you have that discipline, however, and like the idea of a more open-ended source of funds, the line of credit might be the option for you.
Home-Equity Loans and HELOCs
The Smartest Way to Tap Your Home Equity
Refinancing Your Home Equity Loan: A How-to Guide
5 Reasons Not to Use Your Home Equity Line of Credit
How a HELOC Fixed-Rate Option Works
Refinancing vs. Home Equity Loan
Home Equity Line of Credit: 4 Ways to Refinance
Is Your Home Equity Line of Credit (HELOC) Tax Deductible?
Bad Credit? You Can Still Get a Home-Equity Loan
Mortgage vs. Home Equity Loan: How They Differ
What to Do If You Can't Pay Back a Home Equity Loan