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A home equity loan is a type of loan in which the borrower uses the equity in their home as collateral. The home's value minus any outstanding mortgages determine the loan amount. A home equity loan is typically a lump sum loan with a fixed interest rate and repayment term.
A home equity line of credit (HELOC) is a type of loan in which the borrower can access a line of credit secured by the equity in their home. The borrower can draw on the line of credit as needed and only pay interest on the amount they borrow. A HELOC typically has a variable interest rate and a flexible repayment term.
In summary, a home equity loan is a one-time lump sum loan with a fixed rate and repayment term, while a HELOC is a revolving line of credit with a variable rate and flexible repayment.
Home Equity Loan vs. HELOC:
Consider your financial situation and goals before deciding which option is right for you and weigh the pros and cons of each one. Before making a decision, consult a financial advisor or mortgage professional.
Home Equity Loan
A home equity loan is a single lump sum term loan that is secured by the equity in the borrower's home. That means that if the borrower defaults on the loan, they must cede equity to the lender.
Like other term loans, the borrower and lender agree on repayment terms before the loan is taken. Home equity loans have fixed interest rates and borrowers are expected to make monthly repayments.
Lenders need to know the reason for a borrower to take any kind of loan. Home equity loans can be taken for a wide variety of purposes. One popular reason to take them is to fund home improvements. In that way, a borrower can use their home’s equity to increase the market value of their home.
Loan Collateral and Terms
Like many loans, the collateral that is required is in the name of, home equity loan. That means that borrowers are expected to put up a portion of their home equity as collateral. This kind of collateral is part of why home equity loans are often referred to as “second mortgages”.
Exact collateral (home equity) requirements are dependent on the lender and the details of the loan being sought out. Collateral is essentially a way for lenders to offset some of the risks of lending money. Because larger loans are riskier for lenders, lenders normally require more collateral to be willing to lend larger balances. As a common rule-of-thumb, most borrowers should have at least 15% to 20% equity in their homes before considering a home equity loan.
Another factor that affects both collateral requirements and loan terms is the borrowers’ creditworthiness. A borrower's personal credit score, debt-to-income ratio, and a few less important factors go into the lender’s decision-making process.
“Term” in the context of loans refers to how long the borrower has to pay back the loan’s balance. The home equity loan marketplace is diverse in this regard. Home equity loan terms can range from 5 years to 30 years.
Payments and Interest Rate
The repayment process and interest rates for a home equity loan are determined by the borrower’s creditworthiness. Lenders are more willing to provide lower interest rates to borrowers they view as more trustworthy.
The main factors that lenders usually take into consideration are borrower credit scores and debt-to-income ratios. Other factors such as income and the value of the collateralized equity will also influence their offers.
Pros of a Home Equity Loan:
- The borrower receives a lump sum of money, which can be useful for large expenses or investments such as home renovations, paying for a child's education, or consolidating high-interest credit card debt.
- The interest rate is fixed, so the borrower knows exactly how much their payments will be and can budget accordingly. This is particularly beneficial for borrowers who prefer predictable and stable payments.
- The repayment term is fixed, so the borrower knows when the loan will be paid off. This allows for better planning and budgeting for the future.
- The interest paid on a home equity loan may be tax-deductible, which can provide additional savings for the borrower.
Cons of a Home Equity Loan:
- The borrower must repay the loan in full, including interest and principal, by the end of the term. This means that if the borrower is not able to make the full payments, they may risk losing their home.
- The interest rate may be higher than a HELOC, which can make the loan more expensive in the long run.
- The loan is secured by the borrower's home, which means that if the borrower defaults on the loan, the lender can foreclose on the home.
- Due to the nature of the loan, it may be harder to qualify for than a HELOC, which are often easier to qualify for.
Home Equity Lines of Credit (HELOC)
Lines of credit are a form of rotating credit. Rotating credit means that borrowers can draw funds when they want to, and they can draw only what they need, up to their credit limit. Alongside lines of credit, credit cards are another common form of rotating credit.
HELOCs are simply lines of credit that are secured by the equity in a home. By securing a line of credit with home equity, borrowers can more easily access a cheaper form of rotating credit.
Loan Collateral and Terms
In this sense, HELOCs aren’t very different from home equity loans. HELOCs must also be secured with the equity in a home.
The main difference between a HELOC and unsecured rotating credit (ie credit cards, unsecured lines of credit) is that borrowers stand to lose their homes. HELOCs are safer for lenders, so they are normally less expensive than other forms of credit. However, this means that they are less safe for borrowers. If the borrower fails to repay their HELOC balance (defaults), their home can be foreclosed.
Unlike home equity loans, HELOCs have variable interest rates. That means that as the years pass, the interest rate can go up or down. When rates rise, it also means that borrowers must make higher minimum payments.
Payments and Interest Rate
Like any other kind of financing, interest rates, and terms vary by lender, but all lenders assess borrowers for creditworthiness and tailor their offers accordingly.
HELOCs differ greatly from home equity loans in their processes. HELOCs include two stages:
- Draw period
- Repayment period
Pros of a HELOC:
- The borrower can access a line of credit, which can be useful for ongoing expenses or investments such as home repairs, healthcare expenses, or business expenses.
- The borrower can make payments on the interest only during the draw period, which can help to keep the payments more affordable.
- The repayment term is flexible, so the borrower can choose when and how much to pay. This can be particularly beneficial for borrowers with variable income or those who need more flexibility in their payments.
- The interest paid on a HELOC may be tax-deductible, which can provide additional savings for the borrower.
Cons of a HELOC:
- The interest rate is variable, so the borrower's payments can change over time. This means that the borrower may have to budget for higher payments in the future.
- The borrower is required to pay back the whole amount borrowed, plus interest, during the repayment period. This can become a burden if the borrower is not able to make the payments.
- After the draw period, the interest rate may increase, which can make the payments more expensive.
- The loan is secured by the borrower's home, which means that if the borrower defaults on the loan, the lender can foreclose on the home.
What Are The Differences Between a HELOC And a Home Equity Loan?
There are a few areas where HELOCs and home equity loans vary considerably.
Flexibility
HELOCs offer more flexibility, which can be useful when confronted with ongoing expenses. For example, imagine someone plans a huge home improvement project, but they’re not sure how far they will take it and how much it will cost. With a HELOC, this isn’t as much of an issue, as they can just draw what they need when they need it.
Consistency
Home equity loans come with fixed interest rates and fixed monthly repayments. While less flexible, they offer more stability. In cases where interest rates rise, HELOCs become more expensive. At the same time, a home equity loan’s interest rate will remain the same as when the loan was taken. Then, there is the payment period of a HELOC, when monthly repayments suddenly grow significantly. With a home equity loan, there is no comparable change in costs during the loan’s term.
Cost
In terms of cost, different factors are at play. In terms of the average APR a borrower can expect, home equity loans are higher. HELOC APRs typically start considerably lower than those of home equity loans, but HELOC interest rates can also rise.
The repayment process for each loan type is different. With a home equity loan, the repayment process starts immediately after the lender disperses the funds. With a HELOC, interest payments are required once the borrower draws funds during the draw period. Once the payment period is reached, the borrower repays principal and interest together.
How to find the best Home Equity Loan rates?
There are a lot of home equity loan products on the market. To find the best rates, borrowers can compare different lenders and loan products.
The best rates a borrower can receive are usually based on the borrower’s creditworthiness. Creditworthiness determines which borrowers are willing to provide a loan and the rates that they are willing to offer. So, borrowers can use our calculator to get a glimpse of the best loans available to them.
Borrowers can consider the following factors when comparing lenders:
- Interest rate
- APR
- Collateral (home equity) required
- Loan balance
- Repayment term
It’s important to remember that longer repayment terms typically create lower monthly repayments, but cost more overall by the time the loan is fully repaid.
How to find the best HELOC rates?
The same factors determine HELOC rates as home equity loans. Likewise, there are many HELOCs available to qualifying borrowers. To get the best rates, borrowers can take the time to compare lenders and loan products.
In the long term, borrowers can usually qualify for better rates by improving their creditworthiness. The fastest ways to do this are to increase their credit score and pay off existing debt. With a higher credit score and a lower debt-to-income ratio, it can be easier to qualify for a better HELOC with better rates.
Borrowers can consider the following factors when comparing lenders:
- Interest rate
- APR
- Collateral (home equity) required
- Repayment term
- Credit limit
Which One Would be Better For You?
In conclusion, both a home equity loan and a HELOC can be useful for borrowing against the equity in a home, but they each have their own unique features and benefits.
A home equity loan is best for borrowers who need a lump sum of money for a specific purpose, such as a home renovation or a large purchase. The fixed interest rate and repayment term make it easy for the borrower to budget and plan for the loan.
On the other hand, a HELOC is best for borrowers who need ongoing access to credit or who have multiple expenses they need to cover. The flexible repayment term and ability to make interest-only payments during the draw period can make it a more affordable option for borrowers.
It's important to compare the interest rates, fees and other terms of each option and consider your own financial situation and goals before deciding which one is the best for you. It's also recommended to consult with a financial advisor or a mortgage professional before making a decision.
Article Topics
Home Equity
Myles has been covering trends in personal finance for years. He writes for a number of financial blogs, columns, and fintech startups. With extensive knowledge of business financing and the financial challenges of business owners and individuals, Myles puts his skills to use by providing engaging and useful information.
