Key takeaways

  • Home equity loans and HELOCs are both financing tools that allow you to borrow against your ownership stake in your home.
  • Both act as second mortgages, use your home as collateral and may offer tax deductions if the funds are used for substantial repairs or upgrades.
  • Home equity loans come with fixed interest rates and set monthly payments for the life of the loan.
  • HELOCs (home equity lines of credit) come with variable interest rates and fluctuating monthly payments (like credit cards).

Home equity lines of credit (HELOCs) and home equity loans are similar methods of borrowing money against the ownership stake you have 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 tap up to 85 or 90 percent of the value of your home minus your outstanding mortgage balance.

Let’s look more closely at how HELOCs and home equity loans work, and how to determine which would work best for you.

Understanding home equity loans and HELOCs

Let’s compare and contrast the features of these two forms of financing.

Key differences between HELOCs and home equity loans

A home equity loan is a secured installment loan that allows you to borrow a set amount against your equity at a fixed interest rate and repayment term. A home equity line of credit (HELOC) is also a secured debt product. But it’s a revolving debt that offers an amount of funds (a replenishable balance, similar to a credit card limit) tied to the level of equity in your home.

Home equity loans come with a fixed interest rate and repayment term. So, your monthly payment will remain the same over the life of the loan. By contrast, HELOCs have a variable interest rate, which 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 fluctuating, rate. However, you will only pay interest on the funds you draw. This isn’t the case with home equity loans: The interest is added to the entire loan amount since you receive the funds in a lump sum.

Similarities between HELOCs and home equity loans

HELOCs and home equity loans act as second mortgages, using your property as collateral for the debt. So, defaulting on the monthly loan payments means the lender could foreclose your home.

Both funding options allow you to use the funds however you see fit. Some use them to pay for major repairs or renovations, like finishing a basement, remodeling a kitchen or updating a bathroom. Others pay off high-interest credit card debt to save money.

You can expect closing costs whether you choose a home equity loan or HELOC. These expenses should be considered when deciding which option is best for your financial situation.

Before we get into more details, a brief look at the home equity lending scene today.

Home equity lending is having a moment. Originations of home equity loans are up 24 percent year over year, from Q2 2022 to Q2 2023, according to TransUnion’s latest “Home Equity Trends Report.” Their HELOC cousins are highly popular too, up 7 percent in the same period.

Why? It’s mainly RIIR (the rise in interest rates) throughout 2022 and 2023 — particularly mortgage rates, which have doubled since their mid-pandemic lows. That’s pretty much decimated the appeal of cash-out refinancing, once the go-to way to tap a homeownership stake. Hence, the interest in home equity loans and HELOCs; while they’ve risen too, they remain cheaper than other forms of debt, like credit cards.

Of course, all this is made possible by the record-setting rise in home prices since the start of the pandemic, which has increased the value of homeowners’ equity stakes. The average mortgage holder now has $199,000 in equity, up from $185,000 in Q1 2023, according to Black Knight, a real estate data analysis firm.

$10.5 trillion

The sum total of  tappable equity – the amount that can be accessed while still leaving a 20 percent equity cushion – possessed by U.S. homeowners as of mid-2023.

Source: Black Knight “Mortgage Monitor” August 2023 Report

Pros and cons of a home equity loan

Advantages

  • You’ll have 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.
  • Loans often don’t charge origination fees, 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.

Disadvantages

  • You’ll need to know exactly how much you want to borrow. If you don’t, you might end up with 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.

Pros and cons of a HELOC

Advantages

  • You have the option to pay only interest during the draw period; this might mean your monthly payments are more manageable compared to the fixed payments on a home equity loan.
  • You don’t have to use (and repay) all of the funds you’ve been approved for. Interest is charged solely on the amount you’ve borrowed.
  • Some HELOCs come with a conversion option that allows you to set 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.)

Disadvantages

  • HELOCs have variable rates. In a rising-interest rate environment, that means you’ll pay more. This unpredictability could wreak havoc on your budget.
  • Many HELOCs come with an annual fee, and some come with prepayment penalties, aka cancellation or early termination fees, if you pay your line off sooner than the repayment schedule dictates.
  • You could lose your home to foreclosure if you don’t repay the line of credit.

Loan specifications

Home equity loans generally come with long repayment terms, sometimes up to 30 years. The exact terms and the interest rate depend on your credit score, payment history, income and the loan amount. Your home acts as collateral, and the lender can foreclose on it if you default on the loan payments.

With a HELOC, you’ll only be able to use the funds during the draw period — typically the first 10 years. 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.

Requirements for HELOCs and home equity loans

Each lender has its own eligibility criteria for home equity loans and HELOCs. However, here are some general guidelines to keep in mind:

  • Credit score: A credit score of 620 could be enough with some lenders, but aim for 700 or higher to have the best approval odds (and get the best interest rates).
  • Income: Your income should be consistent and verifiable.
  • Debt-to-income (ratio): You’ll need an acceptable DTI to qualify for funding.
  • Equity: Lenders generally allow you to borrow from 80 and 90 percent of your home equity, which is the difference between your home’s value and what you owe.
  • Appraisal: The lender will require an appraisal to determine how much your home is worth or its fair market value. (Note: The appraisal is arranged by the lender, and the fee is included in the closing costs).

Obtaining a home equity loan or line of credit

How to obtain a home equity loan

Home equity loans are available through banks, credit unions and online lenders. Some offer online prequalification tools that let you view loan offers with estimated monthly payments and terms without impacting your credit score. (Note: Some of these tools are used to pre-approve you for a loan and could temporarily ding your score. Read the fine print to confirm).

If you decide to formally apply, you can typically start the process online and upload the requested documentation to get a lending decision. You can also visit a branch if you’re doing business with a traditional bank or credit union. Either way, formally applying for a home equity loan will result in a hard pull that impacts your credit score.

Note: Home equity loans come with a three-day cancellation rule, aka the right of rescission. It allows you to back out of the contract without penalty within three business days.

How to obtain a HELOC

The process for obtaining a home equity loan and HELOC are similar. The three-day right of rescission rule also applies. That said, the disbursement method varies between the two, as mentioned above.

Choosing between HELOC and home equity loan

Which type of loan is better for your needs?

A home equity loan could be a good fit if you know exactly what you’ll use the funds for and how much you’ll need. A home equity loan could also be ideal if you prefer a fixed interest rate and monthly payment that won’t ever change.

However, A HELOC could be ideal if you don’t know exactly the total amount you’ll need, or if your expenses will extend over a long period of time (like paying a home contractor in installments, or college tuition for four years). You have to not mind fluctuating payments.

Can you have both a HELOC and 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 charge higher interest rates on additional loans or lines of credit, especially if you ask for a second loan from the same lender. Also, be mindful that all loans collectively count towards your home equity debt limit in the eyes of the IRS. This could affect your ability to take interest from the loan or HELOC as a tax deduction.

Bottom line on home equity loans and HELOCs

Home equity loans and HELOCs both 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.

Additional reporting by Allison Martin