HELOC vs. Home Equity Loan: What’s the Difference?

Home prices have soared in recent years, and many homeowners have seen their home equity soar, too. There are two relatively easy ways to tap into that equity if you need cash for an expense: a home equity loan or a home equity line of credit. 

Both types of financing act as a second mortgage, meaning you can keep your first mortgage rate intact. Home equity loans and HELOCs both come with lower rates than options like credit cards and personal loans, but they also come with a risk: You’re putting your home on the line. If you default on payments, your lender can repossess your home. 

The major differences between a home equity loan and a HELOC include the type of interest rate, how the funds are disbursed and how you’ll repay your loan. Read on to learn more about each of these home loans to determine which is the right fit for you.

How to calculate home equity

Before you consider applying for a home equity loan or a HELOC, calculate how much you currently owe on your first mortgage and how much your home is worth. The difference between those two figures represents your home equity. 

If your home is currently worth $375,000, for example, and you have $200,000 left to pay on your mortgage, you have $175,000 worth of equity in your home. That equals 47% equity. 

$375,000 – $200,000 = $175,000 

$175,000 / $375,000 = 47% equity

How much home equity can you use?

Lenders typically want you to have at least 15% to 20% equity in your home before you borrow money against your property. Most lenders will allow you to borrow around 75% to 90% of your loan-to-value ratio, or LTV ratio, which is your outstanding mortgage balance divided by your home’s current appraised value. The fastest way to build home equity is to make a large down payment and consistent, on-time mortgage payments over the years. 

What is a home equity line of credit?

A HELOC functions like a credit card, allowing you to borrow against the equity you’ve built in your home. It provides a revolving line of credit that you can access for a certain amount of time, called the draw period. The duration of the draw period is usually 10 years. One of the benefits of a HELOC is that you’re only required to pay back the interest on the money you’ve withdrawn, so you can borrow a large amount for an extended period of time while only making minimum monthly payments. 

HELOC: Pros and cons

HELOCs typically have variable interest rates like those attached to your credit card debt. Unlike mortgages, HELOC rates are directly tied to an index -- the prime rate -- that moves in lockstep with the federal funds rate. When the Federal Reserve hikes rates, it becomes more expensive to borrow with a HELOC. But when the Fed cuts rates, as it might do in the back half of the year, a HELOC’s borrowing costs are cheaper.

Advantages of a HELOC

Interest-only draw period: You don’t have to make payments on your principal loan balance during your draw period. Instead, you can make minimum payments on just the accrued interest. That keeps your monthly payments extremely low for the first decade of your loan. 

Limited closing costs: Some lenders offer HELOCs with limited closing costs (or in some cases, no closing costs at all). However, it’s important to note that several lenders charge annual fees for HELOCs. If you have the line of credit open for 30 years, that’s a lot of annual fees.

Flexible access to funds: You can withdraw up to the maximum amount of your credit limit whenever you need, for whatever you need. Some lenders will have minimum withdrawal amounts, or a maximum number of withdrawals you can make during your draw period, but it should be more than enough for the average homeowner.

Disadvantages of a HELOC

Variable interest rate: A variable interest rate can be a disadvantage. If interest rates are going up, it means that your HELOC rate will rise too, making your monthly payments more expensive. However, some lenders offer the option to convert a HELOC into a fixed-rate loan -- an option worth considering if you want the stability of a fixed monthly payment.

Interest-only draw period: While low monthly payments during the beginning of your loan may sound appealing, the drawback is that you won’t be making a dent in your principal balance for years. So if you just make interest-only payments during your draw period, you’ll still have a huge sum to pay off once your repayment begins. 

Your home is collateral: When your home is the collateral that secures your loan, it means your bank or lender can repossess your home if you miss payments. Don’t put yourself at risk of losing your home, especially if you’ve had issues paying back loans in the past. 

What is a home equity loan?

A home equity loan gives you a lump sum of cash at a fixed interest rate and on a fixed repayment schedule. You make monthly payments on your full loan amount, plus the interest from the very beginning of the loan. Your payments and interest rate do not change over the loan term, whether it’s 10, 20 or 30 years. A home equity loan doesn’t replace your primary mortgage like a refinance -- it’s a brand-new home loan that you must repay monthly along with your existing mortgage payment.

Home equity loan: Pros and cons

A home equity loan has a fixed interest rate, which is ideal in a rising interest rate economy, but it’s also less flexible than a HELOC and has its downsides to consider. 

Advantages 

Fixed interest rate: Your rate is locked in, so even if interest rates rise, you’ll get to keep your rate, saving you thousands of dollars over the lifetime of your loan.

Fixed monthly payments: Because your interest rate doesn’t change, your monthly payment won’t either. A home equity loan can help minimize surprises to your budget, compared with a variable rate HELOC.

More widely available: While HELOCs are also a common product, home equity loans might be slightly easier to find. Rocket Mortgage -- one of the biggest names in home loans -- offers home equity loans, for example, but doesn’t have a HELOC product.

Disadvantages 

Lack of flexibility: A home equity loan gives you one lump sum payment upfront, so you need to have an exact figure in mind for what you need. For example, if you’re investing in home improvements like a kitchen remodel and the project goes over budget, you aren’t going to be able to access more money. 

Your home is used as collateral: Just like a HELOC, your property serves as collateral for your loan. That means your bank or lender can take ownership to pay themselves for your loan if you don’t. 

Cost of borrowing is still high: Home equity loan rates are relatively affordable, which means they’re lower than credit cards. Still, they aren’t cheap. Average home equity loan rates have been hovering around 9% at the beginning of 2024. If you take out a $75,000 30-year home equity loan with a 9% interest rate, you’ll pay more than $142,000 in interest over the life of the loan. 

HELOC vs. home equity loan: Which is better?

These two types of loans share a major upside: the ability to deduct interest on your taxes. If you’re investing in home improvements that will increase the value of your home, you can likely deduct the interest from a home equity loan or a HELOC on your taxes.

Remember that borrowing with either a home equity loan or HELOC comes with a major risk: losing your home. Putting your home up for collateral is no small consideration. 

A HELOC is a better choice if:

• You’re not completely sure how much money you’ll need
• You’d like to have smaller payments initially
• You need the money fast (some HELOC funds are available in less than a week)

A home equity loan is better if:

• You aren’t comfortable with a variable interest rate
• You want one lump sum of cash
• You want a shorter term length (some home equity loans have five-year repayment terms)

Requirements for a home equity loan or HELOC

Just as you had to meet certain requirements to take out your first mortgage, you’ll need to satisfy a number of conditions to qualify for a home equity loan or a HELOC. These vary from lender to lender, but generally speaking, a higher credit score and lower amount of outstanding debt will put you in the running for the best terms.

Credit score: While some lenders may accept a credit score as low as 620, most lenders are looking for higher scores of 660 and above. And if you’re trying to take out more money (up to 90% equity), you’ll likely need a score of 740 that puts you in good to excellent territory.

Amount of equity: Most lenders like to see an 80-to-20 loan-to-value ratio. 

Debt-to-income ratio: While a 43% DTI is ideal for many lenders, some companies will accept up to 50%.

HELOC rates vs. home equity loan rates: What’s the difference?

The average HELOC rate was hovering just above 9% at the beginning of 2024, while the average rate for a home equity loan is just below 9%, according to CNET’s sister site Bankrate. While those rates are nearly identical right now, it’s important to understand the forecast for the rest of the year if you’re comparing the two options. 

Remember that HELOCs have variable interest rates, so your rate will rise and fall in response to the changing economic climate, making your monthly payments inconsistent. In comparison, your home equity loan payments will be the same each month for the lifetime of your loan because it has a fixed interest rate that will never change.

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