A home equity loan and home equity line of credit (HELOC) are alike in that both are secured by your home, just like the first mortgage you obtained to buy your place. That’s why home equity loans commonly are referred to as “second mortgages.”
Both loans are usually for shorter terms than first mortgages. Home equity loans and HELOCs are paid off within five to 20 years, while 30 years is typical of a first mortgage.
But there are several differences between home equity loans and HELOCs, and it’s important to understand them if you’re considering an equity loan.
Home equity line of credit (HELOC)
A HELOC works more like a credit card. You are given a line of credit that is available for a set timeframe, usually up to 10 years. This is called the draw period, and during this time you can withdraw money as you need it. HELOCs come in two varieties: one with an interest-only draw period, or one with a draw period where you can pay interest and principal. The latter option helps you pay off the loan faster.
As you pay off the principal, your credit revolves and you can use it again. When a line of credit has expired, you enter the repayment period, which can last up to 20 years. You’ll pay back the outstanding balance that you borrowed, as well as any interest owed. A lender may or may not allow a renewal of the credit line.
Let’s say you have a $10,000 HELOC. You borrow $5,000, then pay back $3,000 toward the principal. You now have $8,000 in available credit. This gives you more flexibility than a fixed-rate home equity loan.
A HELOC has a variable interest rate that is tied to a benchmark interest rate, such as The Wall Street Journal Prime Rate. As the prime rate moves up or down, so does your HELOC rate. Payments will vary depending on the interest rate and how much credit you have used.
See Bankrate’s breakdown of current home equity loan rates.
The borrower accesses the line of credit using specially issued checks or a card that looks like a credit card. Lenders often require you to take an initial advance when you set up the loan, withdraw a minimum amount each time you dip into it, and keep a minimum amount outstanding.
Financial institutions treat a home equity loan just like they do a mortgage: You must pay off the loan or line of credit when you sell the house. And if you fall behind on payments or default on either loan, a lender can foreclose on your home.
Home equity loan
A home equity loan is a term loan in which the borrower gets a one-time lump sum. The loan is repaid over a fixed term, at a fixed interest rate, with equal monthly payments.
Use Bankrate’s loan repayment calculator to crunch the numbers.
Let’s say a lender gives you a $30,000 home equity loan at a fixed rate of 5.69 percent and 10 years to pay it off. Your monthly payments, including principal and interest, are $328.41 every month. Over 10 years, you will pay $9,409.25 in interest, bringing your total payments to $39,409.25.
Interest rates on home equity loans are typically a little lower than they are for HELOCs.
Use Bankrate’s home equity loan rates tables to get the most current rates.
HELOC vs. home equity loan: Which is right for you?
The answer to this question is seldom black and white. But there are some scenarios in which the choice is obvious.
For example, let’s say you need $7,000 to pay for your daughter’s wedding next month and $3,000 to fix your roof, which will take a week. You know exactly how much you need, and both amounts are due in full soon. If you don’t have plans to borrow again, a straight home equity loan for $10,000 is the way to go.
But if you need money over a staggered period — for example, at the beginning of each semester for the next four years to pay for Jimmy’s college tuition or for a remodeling project that will take three years to finish — a line of credit is ideal. It gives you the flexibility to borrow only the amount you need, when you need it.
And if you borrow relatively small amounts and pay back the principal quickly, a line of credit can cost less than a home equity loan.
Credit-card debt consolidation a popular use of home equity
Consumers with a lot of credit card debt often will borrow a lump sum and pay off their high-interest accounts. Oftentimes, they’ll save money because the interest rates for home equity loans and HELOCs are lower than those for credit cards. Fixed-rate home equity loans are used more often than HELOCs for this purpose.
Borrowing home equity: Questions to ask yourself
To help you determine which loan best suits your needs, ask yourself:
- When do I need the money?
- For how long do I need the money? Is it for a short-term purpose or long-term need?
- How long do I need to repay the loan?
- What monthly payment can I handle?
- Would a revolving line of credit tempt me to spend the money
Questions to ask your lender
Be sure to ask your lender these questions:
- How long is the term of the home equity loan?
- How long do I have to pay it off?
- How long is the draw period and repayment period of a HELOC?
- How large a line of credit do I qualify for?
- Is my line of credit renewable when the loan expires?
- What are the interest rates?
- Do I have to use my credit line right away? (If you’re opening a credit line for future needs or emergencies, you’ll want one that doesn’t require a minimum draw at closing.)
- Under what circumstances can you freeze or reduce my loan, or demand full payment?
- Can I rent out my house during the time of the loan?
- Will you loan to me if my house is on the market (and at what rate)?
- If interest rates go down, how much will my payments drop?