Last Updated: April 15, 2022
Home equity loans and HELOCs do the same in theory: they allow you to borrow against your home equity, but there are important differences.
Let’s break down home equity loan vs HELOC, how they work, what their pros and cons are, as well as their main differences. This will help you decide which option suits your needs best.
Home Equity Loan
First, let’s see how it works:
How Equity Loan Works
What is a home equity loan? A home equity loan (also known as a second mortgage) is a type of consumer debt. They enable homeowners to borrow money against their home’s value. The loan amount is determined by the difference between the current home market value and the homeowner’s mortgage balance due.
A combined loan-to-value ratio (CLTV) of 80% to 90% of the home’s appraised value is used to determine how much a homeowner will borrow. Traditional home equity loans, like conventional mortgages, have fixed repayment terms, like the date. The borrower makes a fixed monthly payment that covers both principal and interest on a regular basis. If the loan is not paid off, the house will be sold to cover the outstanding debt, just like any other mortgage.
Depending on the lender, to fulfill the loan terms you’ll need a certain amount of equity in your house, good credit, a low debt-to-income ratio, ample income, and consistent payment history.
Home equity loans offer the borrower a single lump-sum payment that is repaid over a fixed period of time (usually five to 15 years) at a predetermined interest rate. The payment and interest rate remain constant. Experts say to make sure to compare terms and home equity loan rates at different banks, not just go for the largest bank in your area.
Check out the highest-rated home equity loans we’ve gathered for this. For reference, the average interest rate for a 15-year fixed-rate home equity loan is currently 5.82%.
Pros and Cons of a Home Equity Loan
What are the pros and cons of home equity loans?
Some of the advantages of a home equity loan include lower, fixed interest rates – Whatever the state of the economy, home equity loans will almost always have some of the lowest interest rates.
Proceeds that can be used for any purpose – Many taxpayers have avoided itemizing their mortgage interest, despite the fact that the interest might not be deductible if the loan isn’t used for home improvements. So, the low cost to borrow the money trumps the tax deduction you might be missing out on.
Your home is at risk since it is used as collateral – If you are unable to make your payments, you will face foreclosure. You’ll want to choose a loan amount, term, and interest rate that will allow you to repay the loan in a timely manner.
Not able to get a home equity loan with too much debt or poor credit – A credit score of at least 620, a debt-to-income ratio of no more than 50%, and a steady income are usually needed. If you’re a first-time homebuyer with bad credit you might want to look into ways on how to optimize your situation.
Home Equity Line of Credit (HELOC)
Now let’s see how HELOC actually works:
How It Works
So, what is a HELOC? A HELOC (Home Equity Line of Credit) is a revolving line of credit, similar to a credit card, that you can use whenever you want. Many banks have a range of ways to access those funds, including online transactions, writing checks, and using a credit card linked to your account.
And how does a home equity line of credit work? Similar to a credit card, the amount of available credit is replenished when you repay the unpaid balance. This means you can borrow against it again if needed. The repayment period starts at the end of the draw period and is typically 20 years.
You must have available equity in your home to qualify for a HELOC, which means the amount you owe on your home must be less than the value of your home. In addition, a lender would look at your credit score and background, work history, monthly wages, and monthly debts.
Unlike home equity loans, HELOCs usually feature variable interest rates. The rates can fluctuate from month to month. The variable rate is calculated both using an index (a financial predictor that banks use to set interest rates) and a margin (which remains unchanged throughout the duration of the line of credit).
Pros and Cons of a Home Equity Line of Credit
Let’s talk about the pros & cons of HELOC
Pay it off when you like – You should be able to pay off your HELOC balance anytime you want.
Possibility to convert to a fixed-rate product – If you want to lock in a rate, many HELOCs have a feature that allows you to convert your adjustable-rate debt to a fixed-rate loan.
Interest rates may rise – HELOCs may start out with very low rates because they’re adjustable-rate loans. However, they would increase in tandem with the interest rates, ensuring that you’ll end up paying a higher rate than you started with.
Beware of hidden fees – Many lenders would charge you an early termination fee if you leave your loan early. Others can charge you extra fees if you don’t keep your loan balance at a certain level or don’t borrow a certain amount per year.
Differences Between HELOC and Home Equity Loan
The main differences between a home equity loan vs HELOC include the type of disbursement, repayment terms, interest rates, whether they offer points, and what they are best used for.
- Disbursement – Home Equity Loans offer a one-time lump sum, while HELOC offers a revolving line of credit for a pre-approved amount.
- Repayment – Home Equity Loans have a fixed monthly payment, while HELOC has interest-only payments made during the draw period, followed by full monthly payments.
- Interest Rates – Home Equity Loans have fixed interest rates, while HELOCs interest rates can vary, with the possibility of a fixed rate for a specific period of time.
- Points – With Home Equity Loans, lenders may charge points upfront to reduce your interest rate, while HELOC does not offer points.
- Best For – Hope Equity Loans are best for borrowing a one-time sum when you know exactly how much you want, while HELOC is best for situations in which you need funds at various times.
Things to Know When Choosing Between Home Equity Loan and HELOC
Although they both might seem suitable for certain situations, the difference between a home equity loan and HELOC goes beyond just the basic information on interest rates and repayment terms. These are the things you need to take into consideration when choosing between a home equity loan and a HELOC:
Home equity loans have a fixed interest rate that depends on the lender you’ve chosen and on how much you fulfill the loan terms. A HELOC has variable interest rates, which also means that you might find yourself paying a smaller amount one month and a higher amount another month. Although a high jump from low to high-interest rates is not very likely, it could happen depending on the state of the economy.
When it comes to HELOC, lenders may charge a variety of fees, including an annual fee. Depending on the bank, some annual fees may be $65+, or the bank may have no fees. A home equity loan does not have an annual fee.
This type of fee is charged on a HELOC if the line isn’t being utilized. The amounts vary from small $5 account maintenance fees to monthly or annual service fees of $50 and up. This does not apply to home equity loans.
Early Termination Fee
An early termination fee can be charged if you close the account prior to a specified date. Some HELOCs have prepayment penalties of 5% at three years, 4% at four years, 3% at five years, and no penalty after that while others use a single penalty percentage over a predetermined number of years. The difference between a home equity loan and HELOC is that home equity loans do not have this fee.
As with other lines of credit, almost all HELOCs require an initial minimum draw, for e.g. $10,000 or $25,000, depending on the total line of credit amount. Home equity loans do not have a minimum withdrawal as they only involve a one-time payment.
The duration of a home equity loan will range from 5 to 30 years. HELOCs usually allow for a 10-year withdrawal period and a 20-year repayment period.
The borrower gets a one-time payment with a home equity loan, while a HELOC allows the borrower to tap into the line of credit as required. It remains open until the end of the term. Due to the fact that the amount borrowed can fluctuate, the borrower’s minimum payments can fluctuate as well, depending on how the credit line is used.
HELOCs are commonly classified on a credit report as revolving credit, similar to a credit card, rather than a second mortgage.
Making on-time payments on your HELOC will help your credit score. However, just like any other credit account, if you miss a payment, your score will suffer. However, FICO is structured to exempt HELOCs from revolving credit usage estimates because they are backed by your house, unlike other credit lines. With home equity loans, borrowers noticed a drop in credit score points due to this second mortgage, but making on-time payments increases a borrower’s credit score by proving that they are correctly handling their new home equity loan account.
An annual percentage rate (APR) is the annual rate paid or received on a loan or investment, similar to interest rates.
- Fixed APR – This means that you pay the same interest rate for the entire term of the loan, which is the case with home equity loans.
- Variable APR – This means that the annual percentage rate on your credit card can change over time, which is the case with HELOCs.
How Do You Obtain a Home Equity Loan or HELOC?
In order to obtain this type of loan, you need to keep certain conditions in mind. These are the home equity loan terms and HELOC terms you should consider:
Equity You Own
Your cumulative loan-to-value ratio (CLTV) (i.e. the equity you own) is the primary measure used to calculate your qualification and interest rate. CLTV is determined by dividing your home’s value by your current mortgage balance(s) plus your desired loan amount.
Good Credit Score
In order to satisfy most of the banks’ approval criteria, you’ll need a good credit score. As long as you meet the equity criteria, a credit score of 700 or higher would almost certainly qualify you for a loan. Homeowners with credit scores ranging from 621 to 699 can also qualify. However, there are a few mortgage lenders that accept bad credit you could look into if your credit score is poor.
Not Too Much Debt
Reduce your debt-to-income ratio to increase your chances of getting a home equity loan. To fulfill home equity loan terms some lenders demand that your monthly debts account for less than 36% of your gross monthly income, while others might be able to go as high as 43% or 50%.
A consistent income shows lenders that you’ll be able to pay back your loan. Furthermore, lowering your debt-to-income ratio will be easier if your income is higher.
Lenders may be less likely to lend to you if you have a history of late payments or accounts in collections because they see you as a higher risk. To increase the chances of approval, make at least a minimum payment on credit cards or set up automatic payments before applying for a home equity loan.
Other Ways People Can Use a Home Equity Loan or HELOC
Although home equity loans and HELOCs are primarily used for property, lenders have found that there is a way to use these types of loans for various purposes. These are some advantages of a home equity loan and HELOCs:
Paying off Credit Card Debt
The lump-sum you receive from your home equity loan can be used to pay off or consolidate credit cards or other debts. The same goes with HELOC, where you can continue to borrow as needed. Although, of course, you will have to pay off your HELOC loan.
Remodeling Your Home
A HELOC could be a good option if you’re renovating your home or you need a series of payments over time. This is because this loan functions similarly to a credit card.
Significant Home Repairs
HELOCs are best suited for long-term projects, such as significant home repairs. As we mentioned, this type of loan works similarly to a credit card, where you can withdraw as much money as you need. If you wouldn’t like to consider this option, check out the popular home improvement loans you can get instead.
Paying Education Tuition and Fees
A HELOC is one choice for financing tuition expenses, but keep in mind that there are pros and cons of a home equity line of credit when you use it for this purpose. If you own your house, you could be eligible for a HELOC, which you may use to pay for college tuition and other expenses. You could use a home equity loan for the same purpose as well if in need of a larger financial amount upfront.
Paying Medical Bills
Home equity loans and HELOCs can be used for medical financial aid. They offer low-interest rates which can come in handy if you find yourself in a situation where urgent medical attention is needed.
Comparing HELOC vs a home equity loan will show you that they’re similar in many ways, but they also offer very different advantages and disadvantages.
Depending on what you need, request a home equity loan if you require a lump sum amount upfront which you can pay off at a fixed low-interest rate for up to 15-20 years. If you need money for an ongoing project, then opt for a (HELOC) which works like a credit card and has a varying interest rate that fluctuates from month to month.
A home equity loan may be used to consolidate high-interest debt at a lower rate. Homeowners can borrow against their equity to pay off personal debts such as car loans or credit cards.
Extra fees, a lower credit score, and even the possibility of foreclosure are all risks associated with home equity loans. When deciding whether or not this form of loan can fit your financial conditions, keep these factors in mind.
To decide between a home equity loan vs HELOC, you need to take into consideration all the pros and cons, but most importantly, decide whether you want a one-time amount or a withdrawal of payments over a period of time.