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 similar methods of borrowing money against 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 or 90 percent of the value of your home minus your outstanding mortgage balance.
- Home equity loans and HELOCs are two financing tools that let you borrow against your ownership stake in your home.
- Home equity loans allow you to borrow a set amount at a fixed interest rate for a certain term, similar to a mortgage.
- HELOCS (home equity lines of credit) establish a balance of funds (like a credit card limit) that you can tap at will at a fluctuating interest rate.
- Both vehicles use your home as collateral, and may offer tax deductions if used to substantially improve, remodel or repair it.
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.
How you use home equity loan money is up to you. Some use it to pay for major repairs or renovations, like finishing a basement, remodeling a kitchen or updating a bathroom. Some take out a home equity loan to pay off high-interest credit card debt.
Home equity loan collateral and terms
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.
Pros and cons of a home equity loan
- 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.
- 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.
When it makes sense to get a home equity loan
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.
What is a home equity line of credit?
A home equity line of credit, or HELOC, offers an amount of funds (a replenishable balance, similar to a credit card limit) 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 fluctuating, rate.
HELOC collateral and terms
A HELOC is a revolving credit 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 — 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.
HELOCs also use your home as collateral, which puts your home at risk of foreclosure if you default on the payments.
Pros and cons of a HELOC
- 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.)
- 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.
When it makes sense to get a home equity line of credit
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 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 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.
Final word on HELOCs vs home equity loans
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