Home equity borrowing is hot right now.
This year’s red hot housing market is gifting homeowners an average $64,000 of home equity in the first quarter of 2022, according to the most recent Homeowner Equity Insights report by housing data firm CoreLogic.
“If you have established equity, it’s like a savings account you’ve established,” Vicki Ide, vice president and residential lending manager at Tompkins VIST Bank, previously told NextAdvisor. Now’s as good a time as ever to tap into that equity if it can help you reach your financial goals.
Two popular ways to do so are a home equity loan or home equity line of credit (HELOC). Both can be used to fund large expenses, from home renovations that improve the value of your home, to debt consolidation, to medical expenses. And both are secured, or guaranteed, by the same asset — your home.
However, there are some key differences between the two when it comes to how you get the money, how you pay it back, and how the interest is calculated. Here’s everything you need to know about home equity loans vs. HELOCs, and how to choose the best option for your financing needs.
What Is a Home Equity Loan?
A home equity loan is a loan against the value of your home, paid to you in a lump sum. That makes it an attractive option for large, one-time expenses, such as getting a new roof or funding a large-scale home renovation.
A homeowner can “borrow money from a bank, and the equity in their home serves as collateral to the loan,” Elliott Pepper, a Certified Financial Planner and co-founder of Northbrook Financial, told NextAdvisor.
Home equity is the current value of your house minus what you still owe on your mortgage. If your house is valued at $400,000 and you have $100,000 left on your mortgage, you have $300,000 in home equity.
The more equity you have in your home, the more you’ll be able to borrow, typically up to 85% of that equity. The total amount will be influenced by other factors as well, including your credit score and how much other debt you have.
Home equity loans are commonly known as second mortgages because they act as a second loan that’s secured by your house, on top of your primary mortgage. This means that if you default on a home equity loan, the lender can foreclose on your home.
How Does a Home Equity Loan Work?
A home equity loan works like a mortgage, personal loan, or any other installment loan. You’ll take out a lump sum when you apply for the loan, then pay it back with fixed monthly payments over a predetermined period of time.
Most home equity loans have five- to 30-year terms and fixed interest rates. The average interest rate on a home equity loan is currently around 6%, according to Bankrate, which shares an owner with NextAdvisor. Be sure, however, to base your calculations on the annual percentage rate (APR), which factors in fees and the interest rate, rather than the interest rate alone.
Although the money from a home equity loan can be used for almost anything, home equity loans are commonly used to finance home improvement projects. Interest on home equity loans, and on HELOCs as well, is tax-deductible if the funds are used to substantially improve your home and total debt related to the house — including all other mortgages and home equity loans — does not exceed $750,000.
Home Equity Loans and HELOCs Compared
While home equity loans and home equity lines of credit are somewhat similar in that they both borrow against the equity in your home, there are key differences. The two biggest differences are how you access and pay back the funds, and whether the interest rate is fixed or variable.
With a home equity loan, you choose a set loan amount when you apply for the loan and receive the entire sum at once (minus any origination fees) when the loan is approved and the loan proceeds are disbursed. You then pay it back in fixed monthly installments that include both principal and interest, calculated according to a standard amortization schedule.
With a HELOC, you’re granted a credit line up to a predetermined amount, and you can withdraw money as often as you like, as much as you like (up to the credit limit). You’ll only pay interest on the amount you actually use, not the entire credit line. Many HELOCs allow for interest-only payments during the draw period, meaning that you’re only required to make minimum payments that cover the accrued interest, not the principal. Then, when the repayment period arrives, you’ll begin making payments toward both the interest and principal. This can cause your monthly payment to increase significantly if you haven’t been paying down the principal during the draw period.
The other major difference is that home equity loans have a fixed interest rate, while HELOCs typically have a variable interest rate that fluctuates with the prime rate. This means that a rising interest rate environment like we’re in now can cause your HELOC rate — and by extension, monthly payment — to increase unexpectedly. Some lenders offer rate-lock options on HELOCs, but this additional stability typically comes with an increased interest rate or additional fees.
Here are some other key differences between the two:
|Home Equity Loan||Home Equity Line of Credit|
|Typical duration||5 to 30 years||Draw period: 5 to 10 years|
Repayment period: 10 to 20 years
|Paid to you as||Lump sum||Revolving credit|
|Potential fees and closing costs||Up to 5% of loan amount||Various one-time and recurring fees|
|Tax-deductible interest if used for home improvements||Yes||Yes|
|Monthly payments||Fixed payments of interest and principal, according to a standard amortization schedule||Variable payments that can fluctuate if interest rates change. During the draw period, you may only need to pay the accrued interest. During the repayment period, you’ll make payments toward both interest and principal|
Home Equity and HELOC Rates Are on the Rise
The highest inflation in 40 years has yet to wane. The Consumer Price Index showed prices up 8.2% year-over-year in September, barely an improvement from August’s 8.3%.
That has implications for the Federal Reserve’s efforts to bring price growth down, but it also means a lot for consumers, especially those looking to borrow money. The Fed will likely continue to raise its benchmark interest rate – the federal funds rate – in its ongoing bid to stem demand and lower inflation. But that rate affects the cost to borrow money across the economy, particularly home equity lines of credit or HELOCs.
HELOCs often have variable interest rates that are directly tied to an index – the prime rate – that moves in lockstep with the federal funds rate. When the Fed raises rates, it means HELOC borrowers pay more.
Home equity loans with fixed rates aren’t as directly affected, but those rates are set based on the lender’s cost of funds, which also rises as rates go up.
The economic situation means home equity rates are likely nowhere near done rising, experts say. “I don’t expect [rates] to rise at the rate they have been over the last nine to 12 months. But I think they will go up,” Kevin Williams, a CFP and founder of Full Life Financial Planning, told us. “I’m hopeful that they’ll slow down, but we’ve seen a lot of up and down so it seems like there’s still room for them to rise.”
Pros and Cons of a Home Equity Loan
Fixed interest rate versus variable with a HELOC
Lower interest rates compared to credit cards and personal loans
No restriction on use of funds, unlike student loans or other loan types
You can borrow more money than with a credit card or personal loan
If used for home improvements, could be tax deductible
Possible closing costs and fees
Home is collateral and at risk
Borrowing process takes longer than credit card or personal loan
Interest rates are fixed, but higher than HELOC rates
What Is a Home Equity Line of Credit (HELOC)?
“A HELOC is a revolving line of credit secured against the value of the equity in your home,” says Lindsay Martinez, a Certified Financial Planner at financial planning firm Xennial Planning. Like a home equity loan, a HELOC is also considered a type of second mortgage.
With a home equity line of credit, or HELOC, you are given credit up to a predefined maximum amount, similar to how a credit card works. You can tap into that credit line for expenses such as home renovations, or to consolidate higher-interest debt. Because the credit line remains available for a long time — a typical draw period is 10 years — it’s a good way to fund ongoing projects. It can also be a source of funding for future needs as they may arise.
HELOC interest rates are usually much lower than on credit cards, making them an option for people who have high credit card debt and are looking for ways to save on interest payments. Balance transfer credit cards and debt consolidation personal loans are two other popular options for consolidating debt. HELOCs typically have longer repayment periods than balance transfer credit cards and lower interest rates than debt consolidation loans.
How Does a HELOC Work?
As a revolving line of credit, you can tap into a HELOC for what you need at a given moment, similar to a credit card. And, just like with a credit card, you cannot go above the credit limit. You also do not have to use all of it, and you can pay off the balance you owe at any time before the HELOC term ends.
The size of the line of credit will also be limited by the amount of equity in your home; the more equity you have, the bigger the line of credit can be. Your credit score and employment situation also come into consideration.
HELOC terms are also divided into two periods: a draw period and a repayment period. For example, a line of credit might have a draw period of five to 10 years and a repayment period of 10 to 20 years, for a total length of 15 to 30 years.
The draw period is the time during which you can tap into the credit line. Most HELOCs are interest-only HELOCs, which means that during the draw period, you’ll only need to make payments to cover the interest on your balance and not the principal. After the draw period ends, the repayment period begins, and you will be paying back principal plus interest. However, you can still make payments towards the principal during the draw period even if you’re not required to. Doing so could make it easier to transition to the repayment period when the time comes.
Most HELOCs have variable interest rates, meaning that your interest rate could change throughout the life of your HELOC. Typically, HELOC interest rates are determined by adding a certain margin — decided by the lender and based on your creditworthiness — to the prime rate, which fluctuates based on the market. Some lenders may offer fixed-rate HELOCs, but they’re less common.
“When the draw period concludes, the debt outstanding is amortized subject to the terms of the loan,” says Yusuf Abugideiri, a senior financial planner at Yeske Buie. Amortization simply means that, as a loan ages, more of your payment goes toward the principal and less toward interest. You can also make extra payments toward reducing the principal during the draw period.
Like a home equity loan or mortgage, you’ll likely need to pay some upfront fees. “Similar to any home-related loan, there will typically be fees incurred when the HELOC is opened,” says Pepper. These fees can include origination fees, notary fees, title fees, recording fees to the local government, and appraisal fees. There may also be ongoing annual maintenance fees to keep your account open.
Pros and Cons of a HELOC
If used for home improvements, could be tax deductible
HELOC interest rates are lower than a home equity loan, but variable
You may have the option to lock in, or fix, your rate
No restrictions on use of funds
Only pay interest for what you spend
Possible closing costs and fees
Variable rate subject to market conditions
Risk of losing your house if you default
Borrowing process takes longer than credit card or personal loan
How Do You Get a HELOC or Home Equity Loan?
If you want to get a HELOC or home equity loan, start by comparing rates from multiple lenders. Some lenders will let you pre-qualify or check your rate online, while others may require you to call or visit a branch for more information. The rate you get will depend on your credit score, income, and loan-to-value ratio, and may differ from a lender’s lowest advertised rate. Be sure to ask about any fees or closing costs as well, so you can compare the true cost of borrowing.
If you’re an existing customer of a specific bank or credit union, it may be worth checking to see if your bank offers HELOCs or home equity loans. Working with a bank where you’re an account holder could get you a lower rate. But you should still shop around with a few different lenders before you lock in one option.
After you’ve decided on a lender, you’ll need to fill out an application. This can usually be done online, but your lender may have its own requirements. Most lenders require an appraisal of your house in order to qualify for a HELOC or home equity loan, as your home will act as collateral for your loan.
Once you’ve submitted your information, your lender will decide whether to approve your application based on factors such as your requested loan term and amount, your credit score, income, debt-to-income ratio, and loan-to-value ratio. Once you’ve been approved, you’ll receive a lump sum payment (for home equity loans) or be able to start drawing from your credit line (for HELOCs).
Alternatives to a Home Equity Loan or HELOC
While a home equity loan or HELOC can be a great way to use your home equity to fund large expenses, other financing methods may be a better fit for certain situations. Some alternatives you might want to consider include:
- A cash-out refinance: A cash-out refinance lets you tap into your home equity by taking out a new mortgage larger than your current one, and pocketing the difference as cash. The money you borrow is rolled into your new mortgage, so you’ll only have one monthly payment. Although rising mortgage rates are making refinancing less appealing, this method of using your home equity can be a good option for those who can secure a favorable rate.
- A personal loan: If you only need to borrow a small amount, a personal loan might be a better fit than a home equity loan or HELOC. The interest rate will typically be higher and the loan term will typically be shorter, but the debt is usually unsecured and you won’t have to go through a home appraisal or pay closing costs.
- A balance transfer credit card: If you have good credit and are looking to consolidate credit card debt, you may be able to save money by doing a balance transfer onto a credit card with a 0% APR offer. If you can pay off the debt before the 0% introductory period ends, you’ll pay no interest and be able to save money while getting rid of your debt faster. Just be sure to plan ahead carefully; if you’re still carrying a balance by the end of the introductory period, you’ll be charged the regular credit card APR, which can be quite high.
Frequently Asked Questions (FAQ)
When is a HELOC better than a home equity loan?
Home equity loans and HELOCs can be used for similar purposes, but they have significant differences. While the former is an installment loan with your house as collateral, the latter is a revolving line of credit; you can think of it as a low-interest credit card guaranteed by the value of your home.
Knowing what your goals are is the first step to determining which financial tool is right for your situation. Once you know what you want to use the funds for, you will be able to make an informed choice between the two.
A HELOC could be a better option if you don’t need all of the money in a lump sum because you’ll only pay interest on the money you borrow. However, HELOCs have variable interest rates. If rates are rising, then a home equity loan could potentially be cheaper in the long run.
When should I choose a home equity loan over a HELOC?
Its best to consider a home equity loan if:
- You want to borrow a lump sum
- You want a fixed interest rate and fixed monthly payment
When should I choose a HELOC over a home equity loan?
Its best to consider a HELOC if:
- You want access to funds on an ongoing basis
- You want a lower interest rate and you’re okay with the possibility of your rate changing in the future