If you're considering borrowing against your home, you need to understand the differences between a home equity loan vs. HELOC.
A home equity loan and a home equity line of credit (HELOC) both allow you to tap into your equity. But they differ in how you borrow and how your interest rate works.
This guide will help you understand the home equity loan vs. HELOC basics, so you can decide which is right for you.
Home equity loans and HELOCs share some important characteristics. Below, we'll cover some of the ways in which these two types of loans are similar.
Both home equity loans and lines of credit allow you to borrow against the value of your property. However, you can only borrow this way if you have equity in your home. Equity is the value of your mortgaged property minus what you owe on the home. If you have a home valued at $300,000, and you owe $200,000 on your mortgage loan, you have $100,000 in equity.
Lenders will want to appraise your home to determine its value. They'll typically cap the amount you can borrow so you don't owe more than 85% to 90% of your home's value (including your existing mortgage debt and new loan).
Both types of loans also require you to qualify based on your income and credit score.
When you take out either a home equity loan or a HELOC, the interest rates for these can be lower than the rates on a personal loan or credit card.
Additionally, for both types of loans, your interest may be tax deductible. You're permitted to deduct interest paid on a home equity loan or line of credit if you use the proceeds of the loan to cover costs of buying, building, or improving the home you're borrowing against. The home must be your primary or second home in order for you to be eligible for this tax deduction.
Unfortunately, there's a risk to both types of loans. First, you face the possibility of foreclosure if you can't pay. This is because your home equity loan or HELOC loan is secured debt. In both cases, your house is the collateral -- which means if you don't pay, the lender can foreclose on your home. It's also possible that if you take too much equity out of your home, you'll end up owing more than the house is worth. If you need to sell your home, you'd have to pay the outstanding balance, which is the difference between what your home sells for and what you owe.
Although there are similarities between home equity loans and HELOCs, there are also important differences. You need to understand the discrepancies between a home equity loan vs. HELOC to make the smartest choice for your situation.
The biggest difference is in the way money is lent to you. When you take out a home equity loan, you borrow a fixed amount of money for a designated period of time. You might borrow $20,000 for five years with a home equity loan.
A home equity line of credit, on the other hand, doesn't involve borrowing a set amount. Instead, you're approved to borrow up to a certain amount of money which you can draw from over time.
When comparing a home equity loan vs. HELOC, look at the following factors and how they could impact your situation:
A home equity loan is also referred to as a second mortgage. When you take out a home equity loan, the lender appraises your home to determine how much you can borrow. Your qualifications, including income and credit score, will also be evaluated. These help determine the interest rate as well as the loan amount.
Once you've been approved, you'll be given the entire amount up front in a lump sum. You'll pay these funds back on a fixed schedule over the loan term. Your monthly payment will be based on the amount borrowed, term length, and interest rate.
If you take out a fixed-rate loan, you'll have predictable payments with a home equity loan. You'll know exactly what your interest rate and payments will be for the entire duration of the loan -- they won't change while you're paying the loan back. If you're deciding between a home equity loan vs. HELOC, this is an important point to consider.
With a home equity line of credit, the lender also appraises your home -- but this time, the goal is to decide how big your credit line will be. The lender will approve you for a certain amount, such as a $15,000 line of credit.
A key difference between a home equity loan vs. HELOC is that your line of credit can be used just like a credit card. While you're in your draw period, you can borrow as much as you want up to the credit limit. And, once you've paid back what you borrowed, you can borrow again. For example, let's say you have a $15,000 line of credit. You wouldn't need to borrow all $15,000 at once. Instead, you could borrow $5,000 now, and another $2,000 later. And if you borrowed all $15,000, then paid back $4,000, you'd have that $4,000 available to borrow again.
In this case, you'd be allowed to borrow up to $15,000 at any time you want for the duration of the "draw period." You'll have to pay back whatever you borrowed during the "repayment period" when the draw period comes to an end.
The interest rate you'll pay on your line of credit is typically a variable rate, which is tied to a financial index. This is another big discrepancy between a home equity loan vs. HELOC. A variable rate means payments can change based on fluctuations in interest rates. Your payments will be based on the HELOC rates you've qualified for as well as how much you've borrowed at the time.
During the draw period, you might pay interest only on the amount borrowed. When you get to the repayment period, your payments are based on both principal and interest. At that point, your payments are higher -- but you pay off the loan faster, and don't pay as much in interest.
You can access your line of credit using a card or checks. However, there may be a minimum borrowing limit depending upon your lender. And, at the end of the draw period, you'll have to start paying the entire loan back. That means the payment schedule also differs on a home equity loan vs. HELOC.
There's a lot to consider when deciding between a home equity loan vs. HELOC.
If you know how much you want to borrow and need the money up front, a home equity loan is usually the best choice. With a home equity loan, you'll have the certainty of knowing what repayment will involve. Typically, interest rates are also a little lower on home equity loans than home equity lines of credit.
But if you want to have a line of credit available that you can draw from as needed over time, a home equity line of credit is the right financial product.
Ultimately, you need to consider your situation and goals when deciding between a home equity loan vs. HELOC. Regardless of which you choose, borrow responsibly: You're borrowing against your home's equity. And make sure to shop around among the best mortgage lenders to find the most affordable loan options.
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