You may already know that your home gradually builds equity. As an appreciating asset, many homes increase in value over time due to renovations or repairs, shifts in the local housing market, or new developments in the surrounding area. You can also build equity by paying down your home mortgage each month.
You may know you can claim your equity if you decide to sell your home, too. Although, you may be able to take advantage of your equity sooner with a home equity loan or home equity line of credit (HELOC).
Both HELOCs and equity loans draw from your home equity, which is the difference in your remaining mortgage balance and the current market value of your home. Despite this similarity, these financing options have several key differences.
In this guide, we’ll break down the differences between a HELOC and a home equity loan. You’ll also learn more about the best uses for each financing option. Finally, we’ll discuss how to choose between a HELOC and a home equity loan based on your needs.
What is a home equity loan?
A home equity loan is a fixed-rate, secured loan that allows you to borrow against the equity you have in your home. Home equity loans are also referred to as second mortgages, equity loans, or home equity installment loans.
Some lenders will allow you to borrow up to 85% of your equity. However, your actual amount may vary based on your credit score, payment history, and loan-to-value ratio (LTV) or combined loan-to-value ratio (CLTV).
Your LTV measures the amount you still owe on your mortgage compared to the current, appraised value of your home. For instance, imagine you owe $120,000 on your mortgage and your home appraises for $160,000. Input the numbers into the LTV equation to calculate your loan-to-value ratio.
Existing loan balance / current appraised value = LTV
$120,000 / $160,000 = LTV
$120,000 / $160,000 = .75
Multiply .75 by 100 to convert it to a percentage. That leaves you with a loan-to-value ratio of 75%.
Your CLTV is similar to your LTV. However, your CLTV ratio includes all the debts secured by your home. To calculate your CLTV, simply determine the sum of your combined loan balances and divide them by your home’s current appraised value, then multiply by 100 to determine your CLTV ratio.
A lower LTV improves your chances of getting approved for a home equity loan. In most cases, lenders require you to have a LTV ratio of 85% or lower. That means you can only owe a maximum of 85% of your home’s value—or, in this case, $136,000—on all loans secured by your home.
Achieving 15% equity in your home isn’t an impossible task. However, it can take years to establish enough equity to make a home equity loan worth it.
How does a home equity loan work?
If you decide to move forward with a home equity loan, you can often start the process by applying online through a bank or lending institution. After getting approved for a home equity loan, you’ll receive your funds in a lump sum or single payment. Then, you’ll begin repaying the loan principal and interest until you reach your payoff date.
Your home equity loan interest rates will depend on factors like your credit history, annual income, and loan amount. Home equity loan rates are usually lower than other financing options like credit cards. That’s because the loan is secured—or guaranteed—by your home.
As a result, you represent less of a risk to your lender and may qualify for a more affordable rate. Still, it’s important to budget your monthly payments carefully. If you can’t repay your home equity loan, your lender could foreclose on your house.
Home equity loan pros
Home equity loan cons
What can you use a home equity loan for?
One of the major advantages of a home equity loan is its flexibility. Unlike your first mortgage, you can usually use a home equity loan to cover any type of expense, including:
Keep in mind that each lender’s usage guidelines vary. Before accepting the terms, make sure you do your research and find a home equity loan provider that will allow you to use the funds however you need.
How long are home equity loans?
Your home equity loan term may vary based on factors like the loan amount, lending company, and your financial circumstances. However, most home equity loan terms range from 5 to 30 years.
Longer-term home equity loans typically come with lower monthly payments. However, you’ll usually end up paying more in interest throughout the life of the loan.
With that in mind, you may decide to repay your loan early if your financial circumstances change. But make sure to check with your lending company first. Some may charge hefty prepayment penalties that could cancel out potential savings.
What is a HELOC?
A HELOC is similar to a home equity loan in that you borrow against your equity and secure your financing with your home. However, a HELOC works more like a credit card than a traditional loan.
Typically, your HELOC provider will give you a maximum withdrawal limit based on your home equity, credit history, and LTV ratio. You can use as much of the money as you need. Then, you pay it back, plus interest.
Unlike a home equity loan, most HELOCs have variable interest rates. That means your interest rate may change on a monthly, quarterly, or yearly basis based on a financial index. As the index increases or decreases, your monthly payment will, too.
It’s important to note that, like a credit card, a HELOC is a revolving line of credit. If you make payments to reduce your balance, you’ll have more money to spend. Because of this, you’ll have more flexibility when it comes to your funding. Still, it may tempt some borrowers to overspend, since it’s easy to access more cash without applying for a new line of credit.
What can you use a HELOC for?
Like a home equity loan, you can use a HELOC for virtually any expense. However, HELOCs are especially useful for ongoing expenses. For instance, you can set up a HELOC before taking on a major home renovation.
You may also prefer to use a HELOC for upcoming, repeated costs, like college tuition or medical treatments. You can set up your HELOC in advance, then draw money as needed to pay bills.
How long are HELOC terms?
HELOC terms are split into 2 parts: draw periods and repayment periods. Most HELOC draw periods last from 5 to 10 years. During that time, you can withdraw as much money as you need from your credit line. You will usually need to make payments during the draw period. However, some HELOC providers allow you to make interest-only payments until the draw period ends.
After your draw period closes and you enter the repayment period, you won’t be able to withdraw more money from your credit line. Instead, you’ll begin making payments on the money you owe, plus interest. You’ll usually have between 10 and 20 years to repay your loan, though you may be able to negotiate a longer repayment period.
If you chose to make interest-only payments during your draw period, the total cost of your monthly payments may surprise you. With that in mind, make sure you budget for increased monthly expenses to avoid falling behind on your payments.
Which has lower rates, a HELOC or a home equity loan?
Generally, HELOCs start with lower interest rates compared to a home equity loan. However, HELOCs usually come with adjustable interest rates that change based on a financial index. If the index increases, your rates may increase, too.
On the other hand, the interest rates on a fixed-term home equity loan won’t change. Instead, you’ll make fixed monthly payments throughout the life of the loan.
What’s the difference between a home equity loan and a line of credit?
Home equity loans and HELOCs differ in 3 major ways. Let’s take a closer look at these differences and how they could affect your financial circumstances.
Home equity loans typically have fixed interest rates that won’t change over the life of the loan. HELOCs often have variable rates, though you may be able to convert part of your balance to a fixed rate.
As mentioned above, your HELOC’s initial interest rate may be lower than a fixed home equity loan rate. Still, it could increase dramatically if its corresponding financial benchmark changes.
When you get approved for a home equity loan, you’ll receive your funds in a single, upfront payment. The amount is fixed, which means you can’t access more money without applying for another loan.
On the other hand, HELOCs provide an open line of credit you can use as needed. You’ll have a maximum borrowing amount similar to a credit card limit, but you can repay some of the money you owe to increase your spending power.
Home equity loans typically have fixed monthly payments that remain the same throughout the loan term. As long as you make your payments on time, you will repay the balance by your payoff date.
With a HELOC, your payments will vary based on the interest rate and the amount you draw from your line of credit. During your draw period, you’ll have to make payments. However, you’re usually only required to pay interest charges. Once the draw period ends, your payments will increase to include both the principal and interest.
HELOC vs. home equity loan, simplified
Home equity loan
|Variable interest rates
|Fixed interest rates
(You may be able to convert part of your HELOC balance to a fixed rate)
|Withdraw funds as needed
|Pay interest only on the cash withdrawn
|Fixed monthly payments
|Secured by your home
Is it better to use a HELOC or home equity loan?
Choosing between home equity lines of credit or home equity loans depends on a few factors. To help make the decision process simpler, consider the type of costs you need to cover and whether it’s a one-time or ongoing expense.
A HELOC might be a better idea if:
- You want a flexible funding source.
- You know you have ongoing or upcoming expenses, like college tuition or medical treatments.
- You don’t want or need the structure of a fixed-term home equity loan.
A home equity loan might be a better idea if:
- You know how much you need to borrow up front.
- You prefer the structure of fixed terms and set monthly payments.
- You want a clear budget to reduce the risk of overspending.
So, is borrowing against your home equity worth it?
Deciding to take out a HELOC or home equity installment loan requires a substantial amount of consideration. After doing your research, you may even decide that neither option is right for you. And that’s okay.
HELOCs and home equity loans have many advantages, but the risk of losing your home could prevent you from moving forward with either one. Or you may simply not have enough equity to make a home equity loan or HELOC worth it.
If that’s the case, you may consider alternative funding options, like a personal loan. Most personal loans are unsecured, which means you can access funds without worrying about losing your home if you can’t repay the loan.
Your interest rate may be slightly higher, but you can enjoy a clear payoff date and terms that work for your budget. You may even be able to apply for loans tailored to fit your needs, like a home improvement loan or medical loan.
No matter which financing option you choose, take some time to research your options and consider your finances. In doing so, you’ll empower yourself to make the decision that works best for you, while ensuring you can access the money you need when you need it.