Both home equity line of credit — also called HELOC — and home equity loan are a boon for homeowners who want access to large amounts of money. It could be for major home repairs, renovations or to pay high-interest debts such as credit cards, medical bills, or education fees. In both cases, the borrower taps into the equity of their home to obtain that money. So, in the choice of a home equity line of credit vs home equity loan, which one should you go for?
We will help you make that decision by explaining both of these loans in detail and weighing their differences as well as common points. But first, let’s answer a question.
How do you calculate your home equity?
Home equity is calculated using your home’s current value minus any mortgage against it or other liens. To explain it simply, if your house is worth $200,000 and you still have $100,000 left on your mortgage, you have $100,000 in home equity. And, this or a part of it, can be used as collateral for a loan.
Therefore, as your home value increases, your home equity also rises. The longer you take to pay down your mortgage, the equity in your home also increases.
According to financial experts, homeowners should only tap their home equity for things or projects that will add a value of their assets. Keep this point in mind as you unravel the characteristics of a home equity line of credit versus home equity loans.
Even though both kinds of loans make use of your home as collateral — home equity and HELOCs loans differ in terms of how and how much you can access these loan funds and make repayments.
When thinking about either of the two loans, it’s important to do thorough research and weigh all your options. These loans, while very much similar, can make a difference in the overall cost depending on how you plan on using the funds. It’s crucial that you understand your obligations, the terms and conditions of the loan you are choosing, and have a clear idea of how much you’ll end up paying over the duration of your loan. These answers will help you make the best choice.
Before we begin, let us tell you what they are.
What is a HELOC?
A HELOC is a lot similar to owning a credit card; it too has an extended draw period. The average draw period is up to 10 years with repayment period going up to 20 years — giving the homeowner an opportunity to renew HELOCs if needed after it has been paid off.
A homeowner can borrow money as much or as little as they need. When it comes to repayment, they can pay the amount back on a monthly basis or in lump sum amount.
A HELOC is perfect for those who are contemplating long- term or costly home remodeling. It could be for anything ranging from adding a new kitchen island to a new room. Experts agree that HELOCS is better-suited for projects that are incurred in stages. It is also useful when it comes to college tuition fees that will be paid over time. Or, even medical bills. In other words, these borrowers aren’t sure exactly how much money they will be needing and till when.
One significant downside to a HELOC is that the interest rate is variable, which means payments may also vary from month to month. They may be higher or lower compared to the initial rate. Lenders will use an index like the prime rate, or PR, plus some margin amount to determine these rates.
HELOCs often begin with a lower interest rate than home equity loans, but the rate may fluctuate. That means your monthly payment can rise or fall. This interest rate varies and is determined by several criteria, including decisions by the Federal Reserve, investor demand for Treasury notes and bonds, and the banking industry.
There are two types of HELOCs:
- With an interest-only draw period
- With a draw period where you pay interest and principal at the same time
In the latter, the amount of the loan will decrease faster but your payment amount will be higher.
What is a home equity loan?
A home equity loan, aka second mortgage, uses your home as collateral. The homeowner gets a lump sum amount, that too at a fixed interest rate. If interest rates rise during the term of the loan, the consumer will not have to bear the brunt of it. This is a huge advantage over HELOC.
On average, a home equity loan has a term of five to 20 years. The total amount that you can borrow is usually limited to 80 percent of the equity of the home.
A home equity loan is best-suited for debt consolidation, paying off credit card bills with high-interest rates. It is also useful for funding large-scale home renovations. It could be for remodeling a kitchen or bathroom, maybe adding a new sunroom, or some such project.
HELOC vs Home Equity Loan
|Key features||HELOC||Home Equity Loan|
|Home equity as collateral||Yes||Yes|
|Interest Rates||Maybe slightly lower||Maybe higher|
|Variable interest rate||Yes||No|
|Fixed Interest Rate Security||Sometimes||Always|
|Lump sum loan||No||Yes|
|Need-based money withdrawal||Yes||No|
|Paying interest on the amount drawn||Yes||No|
|Interest-only payment option||Yes||No|
|APR and closing costs||Calculated for a set period||Includes fees|
Apart from these differences, there are also certain similarities between a HELOC and home equity loan that will help you understand them better. Let’s explore them.
- Both kinds of loans borrow against your home equity. They are low-cost ways to finance a new addition to the house, putting on a new roof, or paying off the medical and credit card bills.
- Both loans usually have closing costs and fees similar to your mortgage amount. These may include fees such as at the time of application, home appraisal, title search and/or your attorney’s fees. This could range between 2 to 4 percent of the property’s value on an average. However, in the case of HELOC, there might be some additional fees such as discount points and/or maintenance fees or transaction fees every time you want to withdraw money.
- The government favors both HELOC and home equity loan. As per the Tax Cuts and Jobs Act of 2017, borrowers can deduct the interest paid on these loans on certain conditions — if they use the money to buy, build or improve the home that acts as collateral for the loan.
- Both are better and more viable options than using credit cards or personal loans — much lower interest rates.
- In both cases, if you qualify, your interest payments are tax-deductible (it’s not so for personal loans or credit cards) To calculate how much you may qualify for, it’s better to check with a qualified tax professional.
- You could qualify for as low as 3% APR with a HELOC or home equity loan. Of course, it depends on the amount you borrow.
- Generally, lenders are more willing to give you lower rates because you are using your home as collateral.
- Both may involve certain risks and additional costs as you need to deposit upfront costs and fees to begin the borrowing process. Secondly, and most importantly, your house is at stake. God forbid but if suddenly fall behind on your payments or something happens to your home, your home equity loan provider will have the power to foreclose your property. Thirdly, if you are unable to pay back the principal by the end of your loan term, you will need to pay the pending balloon payment in lump sum amount.
Home equity line of credit vs home equity loan: which loan is better for you?
Choosing between a HELOC and home equity loan is easy if you know why you want to borrow cash in the first place. If it’s a big amount of money for a one-time expense or to consolidate other debts, a home equity loan is better. Take out the exact amount you need and just need to repay it later.
However, if you have expenses that stretch over a time period, go with a HELOC. You will only be charged interest on the money you withdraw. It gives you the added advantage and flexibility to have the money readily available when you actually need it.
Another point to keep in mind is that you must compare APRs and other charges between these loans. Choose the one that gives you a better deal. APRs for HELOC and home equity loan are calculated differently.
Home equity loan: APR is calculated using the interest rate, fees, and closing costs.
HELOC: APR is calculated on the interest rate during a set period of time and doesn’t include other fees.
Also, HELOC with its variable rate may cause a lot of fluctuation on your monthly installments. You may choose to switch to a fixed rate once the draw period is over. Or, ensure that you decide on the maximum cap amount.
If you like the predictability of fixed monthly payments, then a home equity loan may be your best choice.
Whichever loan model you choose, make sure you read through the loan estimate and terms and conditions given by your lender. In case of discrepancies, get all your doubts cleared before signing on the dotted line.