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 may literally be 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). Read on to find out the key differences between the two.
- Home equity loans and home equity lines of credit are different types of loans based on a borrower's credit score, repayment history, and the equity in their home.
- Home equity loans come with fixed interest payments for a fixed term, giving borrowers predictable payments over the length of the loan.
- HELOCs are revolving credit lines that come with variable interest rates.
- The draw periods of HELOCs allow borrowers to withdraw from their credit lines, as long as they make interest payments.
Home Equity Loan vs. HELOC: An Overview
A home equity loan is a fixed-term loan is granted by a lender to a borrower based on the equity in their home. These kinds of loans, often referred to as second mortgages, come with fixed interest payments for a fixed term. This takes all the guesswork out of repayment for the borrower, who ends up with reliable payment terms. A home equity line of credit (HELOC), on the other hand, is a revolving credit line that operates a lot like a credit card. Also based on the equity in the borrower's home, a HELOC allows the borrower to take money out against the credit line, make payments, and continue to do so for the length of the loan term—so long as he or she is up to date and doesn't default.
Home Equity Loan
Home equity loans are sometimes called a home equity installment loan or an equity loan. Because the lender uses the equity in your home as collateral, you basically take out a second mortgage on your home, and it works like a conventional fixed-rate mortgage. The amount of the loan is based on a number of factors including the combined loan-to-value (CLTV) ratio—which is normally 80% to 90% of the appraised value of the property—as well as your credit score and payment history.
Just like the amount of the loan, the lender determines the interest rate of your equity loan on your credit score and payment history. According to Bankrate, home equity loan interest rates ranged from 3.79% and 11.99% as of Nov. 8, 2019. The interest rate is normally locked in, your payments are fixed at a set interest rate. This means your payments are equal for the entire term of the loan, and can last anywhere from 5 to 30 years. Whatever the period, you’ll have stable, predictable monthly payments for the life of the loan.
If you’re the type of person who takes a big-picture view of your financial decisions, a home equity loan makes 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 pay for the loan in the long run the minute you take it out. You can reduce that amount if you pay off the loan early or refinance at a lower rate. So if you borrow $30,000 at 5.5% for 20 years, you can easily calculate that the total borrowing cost, including interest, will be $49,528.
Home equity lines of credit or HELOCs are secured lines of credit—secured by the equity in your home. They operate, in part, like a credit card, so they have a revolving credit line that you can use more than once—as long as you keep up your payments.
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 more money.
During the HELOC’s draw period, you have to make payments. These tend to be small—often amounting to just the interest. During the repayment period, payments become substantially higher. That's because you're required to start paying back the principal. During the 20-year repayment period, you must repay all the money you’ve borrowed, plus interest at a variable rate. This jump in payments can result in payment shock. 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.
Payments must be made to the HELOC during its draw period, which usually amounts to just the interest.
With a HELOC, you know that the maximum you’ll potentially borrow is the amount of your credit limit. But it can be difficult to determine the overall cost of a HELOC. That's because you won't know how much you’ll actually borrow. You don’t know what interest rate you’ll pay, either. Bankrate notes that the average HELOC interest rates range between 3.49% and 21.00% as of Nov. 8, 2019. The rate, just like a home equity loan, depends on your creditworthiness, payment history, and amount you're borrowing. And another key point to note: The interest rates for HELOCs is variable, meaning they may go up or down based on the economy.
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 what you’ll use the money for. You’re guaranteed a certain amount, which you receive in full when the loan is advanced.
“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, loan officer at First Financial Mortgage. 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 you'll 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 introductory period.
One thing you should remember is that a 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. “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.
There was some confusion about what 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. Under the law, homeowners can deduct any expenses related to mortgage interest—which includes both types of loans—for tax years between 2018 and 2025. Deductions are limited to $375,000 in qualified loans for single filers or married couples filing separately, or $750,000 for married couples. But there is one condition: The deductions must be derived from funds 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. So 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. There are additional rules, 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 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. 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.