HELOC or Home Equity Loan: Which Is Better?
A home equity line of credit, aka HELOC, and a home equity loan are ways to finance large expenses by borrowing against the equity in your house. Equity is the difference between what you owe on your mortgage and what your home is worth.
"If you need access to cash and your primary driver is the equity in your home, it's a way to convert equity into cash," says Bill Dallas, president of Finance of America Mortgage.
HELOCs can help you cover ongoing costs, and home equity loans are suited to one-time expenses. A HELOC and a home equity loan are also examples of a second mortgage, a loan that uses your house as collateral.
That backing can make a big difference in what you pay to borrow. A lender could charge triple the interest rate for an unsecured loan compared with a HELOC or home equity loan, says Marc Dukes, senior vice president and credit and analytics director, home lending at Huntington Bank.
Here's more about the differences between home equity loans and HELOCs to help you choose the right option for your financial situation.
[Read: Best Home Equity Loans.]
How Does a Home Equity Loan Work?
When you apply for a home equity loan, the loan will be for a portion of your equity and not the entire amount.
Most lenders allow you to borrow 80% to 85% of your equity, according to Rocket Mortgage. If you have $80,000 in equity, a lender might approve a home equity loan of up to $68,000.
If your loan is approved, the amount is disbursed in one lump sum and paid back in monthly installments over five to 20 years, sometimes up to 30 years.
A home equity loan's interest rate and monthly payment are fixed, which provides borrowers predictability and keeps you from adding to your loan.
"From a budgeting standpoint, it removes a temptation to borrow more than you intended or to not pay back the principal as quickly as you intended," Dukes says.
Pros of Home Equity Loans:
-- Receive a lump-sum payment at a fixed interest rate.
-- Pay a fixed monthly payment over a set period.
-- Choose from long repayment terms of up to 30 years for affordable monthly installments, or select a shorter term to pay off debt quickly.
-- Borrow at lower rates than personal loans or credit cards because a home equity loan is secured by your property.
-- Deduct interest on qualified home equity loans used for home renovations. (Consult a tax advisor.)
Cons of Home Equity Loans:
-- You will have to pay a second mortgage on top of the primary mortgage.
-- Your home is used as collateral, which means you could lose it to foreclosure if you stop making payments on your home equity loan.
-- You could pay a higher interest rate for a home equity loan than a HELOC because the rate is fixed for the life of the loan.
-- You could tap too much equity at once, which can work against you if property values in your area decline.
-- You could pay closing costs and other fees.
How Does a HELOC Work?
A HELOC is a revolving line of credit similar to a credit card. You can continuously borrow against the line of credit, using as much or as little as needed for a period of time, and pay interest only on what you borrow.
As with a home equity loan, a HELOC typically allows you to borrow up to 85% of your home equity. A HELOC, however, has a variable interest rate, which means that the rate can change periodically based on market conditions.
Some lenders may specify a period of time in which a HELOC has a fixed rate.
HELOCs have two distinct phases: borrowing and paying back the line of credit. The first phase, called the draw period, is when the HELOC is open to use as needed, and you make minimum payments or interest-only payments on what you've borrowed.
If you want to extend your draw period, you may be able to refinance your HELOC. Otherwise, you will enter the repayment phase in which you can no longer access the line of credit and must pay back your HELOC's principal and interest balance.
"This is typically between 15 and 25 years," Dukes says. "You are solely in a phase of paying back the financial institution."
Pros of HELOCs:
-- Tap into funds repeatedly without reapplying for a loan.
-- Borrow exactly what you need, when you need it and only pay back that amount, plus interest.
-- Deduct interest on qualified HELOCs used for home renovations. (Consult a tax advisor.)
-- Offer flexibility with payoff, including the option to convert a portion of your balance to a fixed rate.
Cons of HELOCs:
-- Loan payments and interest charges can fluctuate.
-- Access to a credit line can tempt some people to overspend.
-- If you can't make payments, you could end up losing your home because it is collateral for the line of credit.
[Read: Best Home Improvement Loans. ]
How to Choose Between a Home Equity Loan and a HELOC
The decision may boil down to what's more important to you: the predictability of a home equity loan or the flexibility of a HELOC.
When to choose a home equity loan:
-- You know the precise amount you need to borrow.
-- You want to know exactly what your monthly payments will be and when you will pay off the loan.
-- You prefer a lump sum upfront.
-- You have at least a good credit score to qualify for a home equity loan, although you may need a very good score for the best rates.
When to choose a HELOC:
-- You want to borrow as little or as much as you need up to your credit limit and then borrow again until the draw period ends.
-- You don't know a precise loan amount but will have long-term expenses such as tuition payments.
-- Your priority is a low interest rate. Interest rates tend to be lower for HELOCs vs. home equity loans.
-- You have a strong credit profile. Lenders prefer applicants with credit scores in the 700s, according to Rocket Mortgage.
-- You know when and how much your variable interest rate might change and you can afford the potential increases.
[Read: Best Mortgage Refinance Lenders.]
Can You Get a Home Equity Loan During the Pandemic?
HELOCs and home equity loans can be harder to come by during the pandemic, even as home prices soar and interest rates remain low. Some lenders have tightened their qualifications, and others have paused applications for loans.
Wells Fargo and Chase are suspending HELOC applications, and Citi has halted applications for home equity loans and lines of credit. Other lenders may offer these products, but you will need to do your due diligence before you take the time to apply.
If you have shopped around but cannot find a home equity loan that meets your needs, luckily you have not reached a dead end.
Home Equity Loan Alternatives:
-- Unsecured personal loan, such as a home improvement loan.
-- A reverse mortgage if you're at least 62.
