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

@maginnis/Twenty20

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. 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 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 your outstanding mortgage balance. These financial options tend to have low interest rates and fair terms because they use your home as collateral. 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 Changes over time
Disbursement of funds Upfront lump sum As needed
Repayment terms Starts as soon as the 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. You can borrow up to a specific amount of your home equity and repay the funds slowly over time.

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 is good news for homeowners who don’t know exactly how much they need to borrow and want to pay interest on only the money they access.

Pros

  • Only borrow as much money as you need.
  • Many HELOCs come without any fees.
  • Flexible repayment options.
  • Possible tax deduction.

Cons

  • Variable interest rates change based on market fluctuation.
  • Having a long-term credit line risks that you’ll overspend and have a larger debt to repay.
  • Could lose your home if you default on the HELOC.

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. Your interest rate depends on 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 use it to pay for major repairs or renovations, like adding a new room, gutting and remodeling a kitchen or updating a bathroom. You can also take out a home equity loan with a low, fixed rate to pay off high-interest credit card debt.

Pros

  • Fixed interest rate means the same predictable monthly payment..
  • Borrow a lump sum you can use for anything.
  • Some home equity loans don’t have any fees.
  • Loan interest may be tax deductible.

Cons

  • The best home equity loan rates and terms go to consumers with good or excellent credit, or a FICO score 670 and up.
  • You need a lot of home equity to qualify — usually 15 percent to 20 percent or more.
  • 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.

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?

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 works best for your budget.
  • You want to consolidate high-interest credit card debt at a lower interest rate.

A HELOC 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.
  • You don’t mind if your payment fluctuates.

How is the coronavirus impacting home equity loans and HELOCs?

You can get a home equity loan or line of credit while interest rates are near all-time lows right now — even as the economy is still recovering from the COVID-19 pandemic

But keep in mind that 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 not cover the entire loan. Because of this, qualifying for a home equity loan could be difficult while the coronavirus pandemic continues. Some lenders have halted home equity products 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:

  • 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.
  • Low 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 can 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. A history of late payments makes it harder to qualify.

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. 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 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.

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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