Home equity line of credit (HELOC) vs. home equity loan: How do they work?

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Home equity lines of credit (HELOCs) and home equity loans are loans backed by your house, and they’re great ways to borrow money if you’ve paid down a significant portion of your mortgage. A HELOC is a line of credit that allows you to borrow as much as you need over time with variable interest, while a home equity loan is a lump sum that is disbursed upfront and paid back in fixed installments.

Most home equity loans and HELOCs allow you to borrow up to 85 percent of the value of your home, minus any mortgage payments, and they typically have low interest rates and fair terms, since you’re using your home as collateral for the loan. Before you settle on a home equity loan or line of credit, you should shop around to find an option with the lowest fees — or no fees if possible.

How the coronavirus is impacting home equity loans and HELOCs

As economic uncertainty continues during the coronavirus pandemic, interest rates have plummeted to all-time lows. With 6.7 million unemployed people looking for work and additional cash flow, getting a home equity loan or line of credit at low rates can be enticing for homeowners.

During a threat of a recession, however, banks rein in home equity approvals due to their high risk if borrowers can’t repay the loan and home values drop. Home equity loans and lines of credit act as a second mortgage. If a borrower gets laid off and defaults on the loan, the primary mortgage must be repaid first using the home’s current value (which might have dropped during a recession).

Only after the first mortgage is repaid in full can the home equity lender recoup the outstanding debt from whatever value is left from the collateral which might be insufficient. Because of this, getting qualified for a home equity loan could be difficult while the coronavirus pandemic continues, and some lenders have halted their offerings altogether.

What is a home equity loan?

Home equity loans let you borrow against the equity in your home with a fixed interest rate and fixed monthly payment. These loans are funded in a lump sum, and you’ll pay back funds over five to 30 years. Because home equity loans have fixed interest rates, your monthly payment will never change.

The average home equity loan interest rate is currently 5.1 percent, but rates can range from 3.5 percent to 9.25 percent. The interest rate you’re approved for depends on multiple factors, like your credit score, payment history, loan amount and income. If your credit improves after you’ve obtained a home equity loan, you might be able to refinance to a lower interest rate or choose to pay off the loan early.

How can you use the money you receive from a home equity loan? It’s really up to you. Some consumers use it to pay for major repairs or renovations, such as adding a new room, gutting and remodeling a kitchen or updating a bathroom. Another common use is taking out a home equity loan with a low, fixed rate to pay off high-interest credit card debt.

Pros of home equity loans

  • Secure a low, fixed interest rate, fixed monthly payment and fixed repayment schedule.
  • Borrow a lump sum you can use for any purchase you want.
  • Some home equity loans don’t have any fees.
  • Loan interest may be tax deductible if used to remodel or improve your home.

Cons of home equity loans

  • The best home equity loan rates and terms go to consumers with good or excellent credit. “Good” FICO scores range from 670 to 739, while “very good” FICO scores are from 740 to 799; a FICO score of 800-plus is considered “exceptional.”
  • You need a lot of home equity to qualify — usually 15 to 20 percent.
  • If property values decline, you might be upside-down on your mortgage, meaning you owe more than your home is worth.
  • You could lose your home if you default on the loan.

What is a HELOC?

A HELOC, or home equity line of credit, is a line of credit similar to a credit card. With this loan, you can borrow up to a specific amount of your home equity and repay the funds slowly over time.

HELOCs have a draw period, or a period of time during which you can access the money, that typically lasts around 10 years. During this time, you’ll be responsible for interest-only payments. That’s followed by a repayment period, where borrowing must cease and monthly principal and interest payments are required. This repayment period usually lasts 10 to 20 years.

HELOCs tend to come with variable APRs, meaning your interest rate could go up or down based on market trends. Currently, the average HELOC interest rate is 4.52 percent, but the average range is between 1.79 percent to 7.99 percent.

Due to the variable interest rate and the fact that you can tap the funds on your own timetable instead of getting it all upfront in a lump sum, this option may be better for consumers who aren’t 100 percent sure how much cash they need or who have long-term financial needs, like college-related expenses.

 Pros of HELOCs

  • Only borrow as much money as you need.
  • Many HELOCs come without any fees.
  • Repayment options can be flexible.
  • You may be able to deduct the interest on your HELOC on your taxes if you use the funds to improve your home.

Cons of HELOCs

  • Variable interest rates can change with the whims of the market.
  • You need at least 15 to 20 percent home equity to qualify.
  • A long-term credit line risks overspending and a larger debt to repay.
  • You might lose your home if you default on the HELOC.

Home equity loan vs. HELOC: Key differences

Below are some of the major differences between a home equity loan and HELOC.

Home equity loan HELOC
Interest rates Fixed Variable
Monthly payments The same every month Could change over time
Average APRs Higher Lower
Funds disbursement Upfront lum sum Use credit as needed throughout the draw period
Repayment terms Repayment starts as soon as loan is disbursed Interest-only payments during draw period; repay principal and interest afterward

How to choose between a home equity loan and HELOC

Home equity loans and HELOCs can both be good options, but one is probably better for your needs.

As you research, get quotes for both HELOCs and home equity loans to see which one might offer a lower interest rate, lower fees and better terms. Also consider these scenarios where a specific option might leave you better off.

A home equity loan could be better if:

  • You know the cost of your project and need to borrow a lump sum of money.
  • You prefer a fixed interest rate that will never change.
  • A fixed monthly payment you can count on fits well into your lifestyle.
  • You want to consolidate high-interest credit card debt at a lower interest rate and pay it off with a fixed repayment plan.

A HELOC could be better if:

  • You want the ability to borrow as little or as much as you want — when you want.
  • You have upcoming expenses like college tuition and don’t want to borrow until you’re ready.
  • You don’t mind if your payment fluctuates.

Best ways to use a home equity loan or HELOC

There are few limits on how you can use your home equity loan or HELOC, but some of the best ways to use your loan include:

  • Pay down high-interest debt, including any credit card debt.
  • Simplify your finances by reducing the number of bills you pay each month.
  • Complete a major home remodeling project.
  • Pay for major home repairs.
  • Help pay for education tuition and fees.
  • Cover emergency expenses, like medical bills.

Can you have a HELOC and a home equity loan?

There is theoretically no limit to the number of home equity loans or lines of credit you can hold at one time. However, it will be harder to qualify with each new application, since you’ll have less and less equity to tap with each successive loan.

If, for instance, you have a home valued at $500,000 and you have 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.

Lenders may also charge higher interest rates on additional loans or lines of credit, especially if you’re asking for a second loan from the same lender. As with any loan product, it’s best to shop around with a few lenders before accepting a loan offer to make sure you’re getting the best rate possible.

How to calculate your home equity

To find out how much home equity you have, subtract the amount you still owe on your mortgage from the value of your house. The difference is the amount of home equity you’ve accrued, and part of that amount can be used as collateral for a loan. You can also use a home equity calculator to find out more.

The amount of money you can tap varies based on your lender and if you’re considering a home equity loan or a line of credit. The maximum is typically around 85 percent of your home’s value, minus your mortgage balance, though some lenders will go as high as 90 percent. The amount you should tap depends on what you’re hoping to use the money for; in general, try to tap the minimum amount you think you’ll need for your goals.

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