Home equity loan vs home equity line of credit

Your home is an asset that provides you and your family with both a place to live and a place for your money to grow.

Once you gain equity in your home—that is, once you owe less on your mortgage than the home is worth—then you have options in terms of how you can put that equity to work for you. Rather than wait until you sell the house to access those funds, you can take advantage of that money now.

Two loans, home equity loans and home equity lines of credit, often referred to as a HELOC, allow you to tap into your home’s equity. In fact, both are particularly good options right now if you need money, but currently have a mortgage with a low interest rate that you want to keep and so want to avoid a cash-out refinance.

Both HELOCs and home equity loans have benefits, but there are important differences between them that you should consider before you decide whether and when to use them.

Understand the similarities and differences

Home equity loans and HELOCs are similar in that you can use the money any way you wish—to pay for home repairs or a remodel, to pay off high-interest loans or medical bills, to start a business or pay for college, or even to use the money to buy another property.

They both typically have low interest rates and favorable terms, and they both have closing costs, which could include an appraisal fee, a loan origination fee, a title search fee, and others. Some HELOCs may also have an annual fee, transaction fees, or other costs.

And while both loans take advantage of the equity you’ve built in your home by using your home as collateral, they differ in how they work.

• Home equity loan
  This loan is straightforward because it has a fixed interest rate and fixed payment terms. You apply to borrow a specific amount, and once your loan is approved, you’ll receive the entire amount all at once, in one lump sum. Then you make your loan payments in regular monthly installments over the term, which can be anywhere from five to 20 or even 30 years. This means your monthly payments will remain the same throughout the loan term.
  
  Your loan’s interest rate is dependent on your credit score and other information; it typically stays fixed throughout the entire term of the loan. Your payments cover both principal and interest, and the repayment period begins as soon as you receive the funds. You must make payments to both your home equity loan and your regular mortgage along the way.
  
  
• HELOC
  This loan works like a credit card. You can borrow against the approved credit line and withdraw money only as you need it. During what’s called the draw period, when you are withdrawing money from the HELOC (typically 10 years), you are usually only required to make interest payments on the money you’ve borrowed. You can also pay down your balance during the draw period and continue to reborrow the funds as you repay them. When your loan’s draw period ends, the repayment period begins, which can range up to 20 years, although your lender may have different terms. You must then begin making payments that cover both the principal and the interest.
  
  HELOCs often have a lower interest rate than a home equity loan, but that rate can change over time. This means that the amount of your monthly loan payment varies according to the amount you’ve borrowed and by the interest rate in place at the time. HELOC loans are typically easier to get than a home equity loan, but lenders can ‘call’ the loan at any time. And, as with the home equity loan, you must continue to pay your regular mortgage.

Comparing the key features of a home equity loan vs. HELOC

How much can you potentially borrow?

The amount you can borrow with either a home equity loan or a HELOC depends on several factors, including the equity you have in your home, your credit score, your income, and other outstanding debt. You’ll need to know the fair market value of your home and the amount remaining on your mortgage to calculate your loan-to-value (LTV) ratio.

Many lenders limit the LTV to 80 or 85%, which means you need to have at least 15 to 20% equity in your home. For example, if your lender limits the LTV to 80%, if the fair market value of your home is $500,000 and you have a $300,000 mortgage balance, your lender may potentially allow a loan or line of credit of $100,000. Here are a few tips for estimating your home’s value; you can also learn more about calculating your LTV.

Which is better—a home equity loan or a home equity line of credit?

Both loans can be a smart way for you to put your own money—the equity you have in your home—to work. Since your home is used as collateral, the interest rate is typically lower than for other types of debt such as credit cards or personal loans, so these funds can give you a good way to reduce your debt at less cost. In addition, the money can be used for anything, as opposed to an auto loan, which is tied to a specific vehicle. And if you use the money to do a value-added renovation project, you increase the value of your home, which helps to increase your overall equity.

Deciding which type of loan is best for you depends on how you intend to use the money and when you need it. 

If you know exactly how much you need and you need the funds all at once, a home equity loan may be your best option. For example, if you want the funds to purchase another property or when you have a one-time expense, such as paying off high-interest debt, or a large medical bill, you’ll need a lump sum, which means a home equity loan might work best. A home equity loan is also a good choice if you want to know exactly how much your payments will be over time. 

If you need the funds over time—to finance your child’s college education or to pay for ongoing repairs to your current home—you may not need the money all at once. This means that a HELOC would be your best choice because it allows you to withdraw money only when needed, and you’re not paying interest on the entire loan from the first day. Some people even apply for a HELOC as a ‘just in case’ emergency source of funding, and then draw on it if needed.

A HELOC can create budgeting challenges, because with the variable interest, you can’t be sure of your future payment amount. But if you’re disciplined and committed to making payments that cover both principal and interest during the draw period of a HELOC, this will help you avoid the problem of suddenly having a large debt payment to make each month. Some HELOC loans come with a balloon payment requirement, though, so make sure you fully understand the terms of your loan. Once you open a HELOC, you aren’t obligated to withdraw the funds. You can just leave the credit line open until you need it.

Which loan is best for you: Home Equity Loan vs. HELOC?

What about taxes?

According to the IRS, for tax years 2018 through 2025, if your home equity loan or line of credit secured by your main home or a second home is used to “buy, build, or substantially improve the residence,” the interest you pay on the borrowed funds may be tax deductible, subject to certain limitations, if you itemize your deductions. However, if you use the loan to pay for personal living expenses, such as credit card debt, the interest you paid is not deductible. But for tax years before 2018 and after 2025, the interest you pay on the borrowed funds may be deductible, subject to certain dollar limitations, regardless of how you use the loan proceeds. These rules may change after 2025, though, so always consult a tax professional.

Things to consider

Everyone’s situation is unique, and the best choice for one person may be a bad fit for another. When considering whether to get a home equity loan or a HELOC, here are some important things to remember:

• You can use the money from your home equity loan or HELOC to make improvements to your property, which can increase the value of the home and increase the amount of equity you have.
• But if the value of your home goes down, you run the risk of going ‘underwater’ or ‘upside down,’ which means the amount you owe for your home (which includes your primary mortgage and your home equity loan or a HELOC) is higher than the fair market value of your home.
• You must continue making payments for both your primary mortgage and the loan. If you fail to make payments to either, your lender can foreclose, and you would lose your home.
• Because a home equity loan usually has a lower interest rate than other options such as credit cards or personal loans, you can save on interest by using the money to pay off the other debt. But you must avoid the temptation to turn around and add more debt.
• Home equity loans are typically not intended for everyday expenses. If you’re thinking about using the money for something like a vacation or a wedding, you may want to consider other options.

There are also a lot of benefits of a home equity loan or home equity line of credit. Each allows you to take advantage of the investment you have in your home, and when used effectively, they can be a smart financial tool.