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Home equity lines of credit (HELOCs) and home equity loans are similar methods of borrowing money via the equity in your home. A HELOC is a line of credit with a variable interest rate, while a home equity loan is a lump sum paid back in fixed installments. Both typically allow you to borrow up to 85 percent of the value of your home minus your outstanding mortgage balance.
What is a home equity loan?
A home equity loan is a secured loan that allows you to borrow a set amount against your equity at a fixed interest rate and repayment term, usually up to 30 years. The interest rate depends on your credit score, payment history, loan amount and income.
How you use home equity loan money is up to you. Some use it to pay for major repairs or renovations, like adding an addition, gutting and remodeling a kitchen or updating a bathroom. Some take out a home equity loan at a lower, fixed-rate to pay off high-interest credit card debt.
Pros of a home equity loan
- You’ll get a fixed interest rate and predictable monthly payment.
- You’ll get all of the loan proceeds at closing and can spend them however you see fit.
- Some lenders don’t charge origination fees on home equity loans, which’ll save you money at closing.
- The interest paid on the loan might be tax-deductible if the funds are used to upgrade your home.
Cons of a home equity loan
- You’ll need to know exactly how much you want to borrow. If you don’t, you might end up borrowing more or less than you need, which means you’ll either be stuck repaying the portion you didn’t use plus interest, or need to borrow more money.
- You’ll need a sufficient level of home equity to qualify — usually 15 percent to 20 percent.
- You could lose your home if you fall behind on the loan payments.
- If property values decline, your combined first mortgage and home equity loan might put you “upside down,” meaning you owe more than your home is worth.
What is a home equity line of credit?
A home equity line of credit, or HELOC, is a credit line tied to the level of equity in your home. Unlike a home equity loan, a HELOC has a variable interest rate, which means the rate can increase or decrease, along with your monthly payments, at preset times. Some HELOCs come with low introductory rates for a period of time (for example, six months), then flip to a higher, but still variable, rate.
A HELOC is a revolving line — you can use the funds, repay them, then borrow them again, much like a credit card. You’ll only be able to use the funds during the draw period, however, typically 10 years. During this time, you might only need to make interest payments. When the draw period ends, you’ll have a certain amount of time to repay what you borrowed plus any interest, usually up to 20 years.
Pros of a HELOC
- You’ll only pay interest during the draw period; this might mean your monthly payments are more manageable compared to the fixed payments on a home equity loan.
- Similar to a credit card, you don’t have to use (and repay) all of the funds you’ve been approved for. This flexibility often makes a HELOC worth having, especially in emergencies.
- Some HELOCs come with a conversion option that allows you to put a fixed rate on some or all of your balance. This might help shield your budget from variable-rate increases. (One caveat, however: Home equity lenders often charge a fee for conversions.)
Cons of a HELOC
- HELOCs have variable rates. In a rising-rate environment, that means you’ll pay more. This unpredictability could wreak havoc on your budget if you don’t plan accordingly.
- Many HELOCs come with an annual fee, and some come with prepayment penalties, also known as cancellation or early termination fees, if you pay your line off sooner than the repayment schedule dictates.
- Like a home equity loan, you could lose your home to foreclosure if you don’t repay the line of credit.
How do I choose between a home equity loan and a HELOC?
While both options have upsides, a home equity loan could be better if you know exactly what you’ll use the funds for and don’t need much flexibility. A home equity loan could also be better if you prefer a fixed interest rate and monthly payment that won’t ever change.
A HELOC, on the other hand, could be better if you want to borrow as little or as much as you want, when you want; you have upcoming expenses such as college tuition and don’t want to borrow until you’re ready; and you don’t mind if your payment fluctuates.
Can you have a HELOC and a home equity loan?
Theoretically, there is no limit to the number of home equity loans or lines of credit you can hold simultaneously, but it’ll be harder to qualify with each new application because you’ll have less and less equity to tap with each loan.
For instance, if you have a home valued at $500,000 and two home equity loans totaling $425,000, you’ve already borrowed 85 percent of your home’s value — the cap for many home equity lenders.
A lender might also charge higher interest rates on additional loans or lines of credit, especially if you ask for a second loan from the same lender.
How does the Fed rate increase impact home equity products?
Lenders often base home equity product rates on the prime rate, which is generally three percentage points higher than the fed funds rate. Consequently, the Federal Reserve’s recent rate hikes have led to more costly home equity loans and HELOCs.
If you’re seeking a home equity loan, you do have some form of certainty regarding borrowing costs because interest rates on these products are generally fixed. This isn’t the case with HELOCs, as they come with variable interest rates. Your monthly payments could continue to rise with subsequent Fed rate hikes.
Home equity loans and HELOCs allow you to borrow money against your home equity, but they’re not the same. Consider the purpose of the funds, how much you need and whether or not you’ll want to borrow more in the future. Once you decide, get your credit in good shape and shop around to secure the best rate.