Home Equity Loan VS HELOC

Home equity loan or HELOC?

Having equity in a home enables homeowners to apply for different kinds of financing. Home equity loans and home equity lines of credit (HELOCs) are two of those options. In both cases, borrowers use their existing equity to secure a new loan. 

For homeowners, equity is the market value of their home, subtracting the balance currently owed on their mortgage. Once homeowners have enough equity, lenders offering these two loan types can consider giving them secured financing.

The difference between home equity loans and HELOCs is simply the form of credit. Home equity loans are lump-sum loans that must be paid back according to a fixed payment schedule. HELOC, being lines of credit, are a form of rotating credit. That means borrowers can draw credit as needed, then must pay it back. 

Let’s delve deeper into how these two loan types work and when borrowers choose to take them.

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.

 

Once a borrower agrees to a loan’s terms and accepts the home equity loan, the interest rate is fixed. The amount the borrower repays is fixed, as is the interest rate. The borrower’s repayments go to both the interest and principal balance of the loan. A greater portion goes towards the interest, then more goes towards the principal after the interest is paid back.

 

Advantages and Disadvantages of Home Equity Loans 

Advantages

Home equity loans enable homeowners to leverage part of their equity to access funds for other purposes. When used properly, they can help borrowers reach a number of goals. One common example is by using the equity in a property to finance home improvements. In this case, borrowers can use their equity to increase the market value of their homes.

The cost of home equity loans can be offset with tax deductions under certain circumstances. When home equity loans are used for home improvements, borrowers may be eligible for a tax deduction on the interest paid. It’s important to be sure of eligibility for a deduction before claiming it. Borrowers can consult tax professionals and refer to the IRS’s resources to check for eligibility.

While the latter benefit is specific to home equity loans for home improvements, home equity loans are diverse. They can be used for a number of expenses and are easier to access than other loans. Because they are secured with a property, lenders view them as less risky than other kinds of loans.

 Disadvantages

Borrowers taking home equity loans are taking at least some risk. In the worst-case scenario, the collateralized home can be sold so the lender can recover the borrower’s debt. This normally happens if the loan is defaulted on or if payments aren’t made. To avoid this pitfall, borrowers can scrutinize their budgets to be as sure as possible that they can repay the loan’s balance.

In some cases, the value of the borrower’s home will decrease during the repayment process. If the value of the borrower’s home decreases significantly, borrowers can end up in an awkward situation. In some cases, they may find that the home equity loan’s balance is higher than the value of the home.

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:

  1. Draw period
  2. Repayment period

The draw period covers all the time during which the borrower can draw funds from their line of credit. Borrowers would be able to continue to draw funds during the entire period, as long as they don’t try to exceed their credit limit. Draw periods last according to the terms of the HELOC; the longer the HELOC is, the larger the window of time to draw funds.

After the draw period ends, the borrower can no longer draw funds. This is where the repayment period starts. During the draw period, borrowers normally only need to repay interest. But once the borrower enters the repayment period, they must also repay the principal. This transition from interest-only to interest plus principal repayments is normally significant. Borrowers may want to prepare in advance to be able to make higher timely repayments during the repayment period.

Advantages and Disadvantages of HELOC

 

Advantages

With a HELOC, borrowers have more ongoing control over their loan product. Borrowers know how much they can borrow if need be. But they also have the flexibility to borrow only what they need. When a HELOC is taken, the borrower can decide how little or how much to draw during the draw period. This can make it easier to adjust how much is borrowed as time goes on.

 

Disadvantages

HELOCs are less fixed than home equity loans. This is also true of HELOCs’ variable interest rates. There is always a chance that a HELOC will become more expensive should interest rates rise. So, while borrowers can control costs by adjusting how much they borrow, it’s impossible to know the full interest cost of a HELOC from the start. They may end up being more expensive, or cheaper than originally thought.

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.

 

Home Equity Loan HELOC
Interest Rate Fixed Variable
Repayment Requirements Same month-to-month Variable amount
APR Higher Lower
Disbursement All up-front When borrower pulls funds

 

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?

HELOC rates are determined by the same factors 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

Is a Home Equity Loan or HELOC right for you?

Most people with equity in a home can qualify for a home equity loan or line of credit. With home equity plus an income, credit history, and necessary paperwork, there are typically plenty of options to choose from.

It is the borrower’s responsibility to determine whether they want to leverage the equity in their home to secure a home equity loan or HELOC. Likewise, it’s the borrower’s responsibility to consider the terms of the loan and make sure they are able to pay back any money they borrow.

In the case of either of these loan products, the amount a borrower can borrow will usually depend on the home’s value and personal creditworthiness. Borrowers are expected to consider their overall financial situation before taking a loan. When a borrower is financially stable and understands their responsibilities when taking a home equity loan or HELOC, they are more likely to benefit from the option. 

Myles Leva Myles Leva Last update:
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.