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 that use your home as collateral, and both can be great for borrowing money if you’ve paid down a significant portion of your mortgage. However, these two financial products don’t work quite the same. A HELOC is a line of credit that allows you to borrow money as needed with a variable interest rate, while a home equity loan is a lump sum that is disbursed up front 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 your outstanding mortgage balance. They typically have low interest rates and fair terms since they use your home as collateral. Still, HELOCs and home equity loans are not created equal. Before you settle on a home equity loan or line of credit, shop around to find an option with the lowest fees — or no fees if possible.

What are the differences between a HELOC and home equity loan?

If you have equity in your home and want to borrow money, you may choose a HELOC or home equity loan. Below are some of the major differences between these options.

Home equity loan HELOC
Interest rates Fixed Variable
Monthly payments Same every month Varies over time
Average APRs Higher Lower
Funds disbursement Up-front lump sum As needed
Repayment terms Repayment starts as soon as loan is disbursed Interest-only payments during draw period; repay principal and interest afterward

 

What is a home equity line of credit?

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

Unlike home equity loans, HELOCs let you access money when you need it and repay it with variable interest. Because of this, you aren’t locked into a specific monthly payment. This can be good news for consumers who don’t know exactly how much they need to borrow and want to pay interest only on the money they access.

Pros Cons
Only borrow as much money as you need. Variable interest rates can change with the whims of the market.
Many HELOCs come without any fees. You can usually borrow only up to 85 percent of your home’s value, minus the balance of your first mortgage.
Repayment options can be flexible. Having a long-term credit line risks that you’ll overspend and have a larger debt to repay.
You may be able to deduct the interest on your HELOC on your taxes if you use the funds to substantially improve your home. You might lose your home if you default on the HELOC.

Takeaway: If you want the flexibility to borrow as much or as little money as you need over time, a HELOC makes sense. You may want to go this route if you’re unsure of exactly how much it will cost to fund your project or venture.

What is a home equity loan?

A home equity loan is a secured loan that lets you borrow against your home equity with a fixed interest rate and repayment term. The interest rate you’re approved for depends on factors such as 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.

How you use the money from a home equity loan is 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 Cons
Secure a low, fixed interest rate, fixed monthly payments and a fixed repayment schedule. 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.”
Borrow a lump sum you can use for any purchase you want. You need a lot of home equity to qualify — usually 15 percent to 20 percent or more.
Some home equity loans don’t have any fees. If property values decline, you might be upside down on your mortgage, meaning you owe more than your home is worth.
Loan interest may be tax deductible if the loan is used to substantially improve your home. You could lose your home if you default on the loan.

 

Takeaway: If you have a specific project in mind and you know exactly how much it will cost, a home equity loan can be a smart choice as it can provide you with a lump sum of cash. Just make sure you don’t plan to borrow more money in the near future.

How do I 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, fewer fees and better terms. Also, consider these scenarios when 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 into your lifestyle well.
  • 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 such as college tuition and don’t want to borrow until you’re ready.
  • You don’t mind if your payment fluctuates.

How the coronavirus is impacting home equity loans and HELOCs

With the Bureau of Labor Statistics reporting a 5.2 percent unemployment rate in August and many more people looking for work and additional cash flow, getting a home equity loan or line of credit while interest rates are still near all-time lows can be enticing for homeowners.

During economic uncertainty, however, banks rein in home equity approvals due to their high risk if borrowers can’t repay the loans and home values drop. A home equity loan or line of credit acts 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.

How do you get a HELOC or home equity loan?

While eligibility requirements for home equity products may have tightened up as a result of the coronavirus pandemic, there are still options available for eligible borrowers. Here’s an overview of what you’ll need to get a HELOC or a home equity loan:

  • Considerable equity in your home: You’ll likely need to have at least 20 percent equity in your home, or an 80 percent loan-to-value ratio, meaning your mortgage balance and any existing home equity loans total no more than 80 percent of your home’s value.
  • Good credit: Although lender requirements vary, in general, you’ll want to have a credit score in the mid-600s to qualify and a score above 700 to get the best interest rates and terms. Some lenders also require a higher credit score for higher loan amounts.
  • A reasonable amount of other debt: Many home equity lenders require a debt-to-income ratio of 43 percent or below. This means your monthly debt payments make up no more than 43 percent of your gross monthly income.
  • Sufficient income: You need to prove you have the funds to repay your loan, although most lenders don’t disclose their income thresholds.
  • Reliable payment history: A long history of on-time payments on other bills can help you qualify for a home equity loan or a HELOC. If you have late payments on your record, it’s likely that they damaged your credit score.

How to find the best home equity loan rates

Home equity loans almost always come with a fixed interest rate and a fixed monthly payment. These loans are funded in a lump sum, which you’ll pay back over five to 30 years.To find the best home equity loan rates, make sure your credit is in good shape.

If it’s not, you might want to take the time to improve it. Then, shop around and compare all of your options. Don’t forget to consider fees and repayment terms.

How to find the best HELOC rates

HELOCs have a draw period during which you can access the money, typically lasting around 10 years. During this time, you’ll be responsible for interest-only payments.

That’s followed by a repayment period, when borrowing must cease and monthly principal and interest payments are required. HELOCs tend to come with variable APRs, meaning your interest rate could go up or down based on market trends.

For the best HELOC rates, maintain good credit, have enough equity, and consider the different types of lenders. Also, understand the introductory rates, look for rate caps, and factor in fees.

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 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.

Bottom line

Home equity loans and home equity lines of credit can allow you to borrow money against your home equity. But they’re not the same. Before you decide which option is best for you, 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 make a decision, get your credit in good shape and shop around to secure the best rate.

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Written by
Ellen Chang
Contributing writer
Ellen Chang is a freelance journalist who is based in Houston. For Bankrate, Chang focuses her articles on mortgages, homebuying and real estate. Her byline has appeared in national business publications, including CBS News, Yahoo Finance and MSN Money.
Edited by
Loans Editor
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