- The average homeowner gained $48,000 in tappable equity in 2021, according to mortgage technology and data provider Black Knight.
- Home equity loans and home equity lines of credit (HELOCs) are two popular ways to borrow against home equity, but they work in different ways.
- A home equity loan is an installment loan with a set loan term, fixed interest rate, and fixed monthly payment.
- A HELOC is a revolving line of credit with a draw period and repayment period, variable interest rate, and variable payments depending on the market interest rate.
- Home equity loans and HELOCs can both be a good option to finance home improvements or consolidate high-interest debt.
2021 brought homeowners across the nation a $2.6 trillion gain in tappable equity — the largest increase on record, according to mortgage technology and data provider Black Knight.
Over the past year, surging demand and low inventory led to a highly competitive housing market that drove up home prices. While this is great news for sellers, even those who aren’t planning to sell their houses can benefit from their increased home equity. The average homeowner gained $48,000 in tappable equity (equity available while maintaining an 80% loan-to-value ratio or less) in 2021, according to Black Knight. That’s a 35% increase since 2020 and brings the average total equity available up to $185,000.
“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 us. Now’s as good a time as ever to tap into that equity if it can help you reach your financial goals.
If you’re looking for ways to access your home’s equity, a home equity loan or home equity line of credit (or HELOC) are two popular options. Both can be used to fund large expenses, from home renovations that improve the value of your home, to debt consolidation, to medical expenses.
Both are available from traditional banks, credit unions, and online lenders. And both are secured, or guaranteed, by the same asset — your home. That means the lender could foreclose on it in the event you do not repay.
However, there are some key differences between home equity loans and HELOCs when it comes to how you get the money, how you pay it back, and how the interest is calculated. Here’s what to know about how home equity loans and HELOCs work — as well as how to choose the best option for your financing needs.
- What Is a Home Equity Loan
- What Is a Home Equity Line of Credit (HELOC)?
- Home Equity Loans and HELOCs Compared
- How Do You Get a HELOC or Home Equity Loan?
- Is a HELOC or Home Equity Loan Better for Me?
- Alternatives to a Home Equity Loan or HELOC
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.
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.
Pros and Cons of a Home Equity Loan
The money that you’ll get from a home equity loan is given to you as a lump sum, which can be a pro for many but a con for others. It depends on your spending habits and preferences, as well as how much money you need to borrow. You can use the money for virtually any purpose — it doesn’t have to be home-related.
Home equity loans have a fixed interest rate, which can provide some measure of stability since your payment will stay the same every month. HELOCs, on the other hand, have a variable interest rate. This could be an issue if market rates rise, directly affecting how much you would have to repay.
Home equity loans come with costs and fees similar to those of a standard mortgage. These costs range in general from 2% to 5% of the loan amount, but it’s possible to get the lender to waive some of the fees, Pepper says.
Another significant con of a home equity loan is that your house is used as collateral for the loan. If you stop making payments, you could be in jeopardy of losing your home. And, if you’re also paying off your mortgage, this is another payment that you’ll need to make each month.
What Is a Home Equity Line of Credit (HELOC)?
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
A HELOC functions as a revolving line of credit secured by your home. Because the typical draw period is around 10 years, it can act as a source of funding for future projects as the need arises — and this can be a pro for many homeowners. Like a home equity loan, a HELOC is tax-deductible if you use the funds to improve your home, as long as total debt related to the house does not exceed $750,000.
On the other hand, a HELOC may also come with ongoing fees, which could include any or all of the following:
- Annual fee, charged every year whether or not you use the credit line. This can also be known as a membership or maintenance fee
- Inactivity fee, charged if you do not use the line of credit for a certain period of time
- Early termination fee, charged if you close your HELOC before the term is up
- Minimum withdrawal requirements, which could lead to unwanted interest costs if you don’t need the money right away
It is possible to have at least some or all of those fees waived if your lender charges them; it never hurts to ask.
HELOC interest rates are typically lower than those of a home equity loan, but they’re also variable. While you could save money if interest rates are low, changes in market conditions could raise rates and, by extension, your monthly payment. For some, this lack of stability may be a significant downside.
Because a HELOC is a line of credit, you’ll also want to be sure to pay your bills on time — late or missed payments can be harmful to your credit score and may even create a risk of foreclosure.
Note that you cannot sell a home until a HELOC is paid off in full, since it acts as a lien against the property. Depending on your needs and goals, this could be a significant con against getting a HELOC.
Home Equity Loans and HELOCs Compared
While home loans and lines of credit are somewhat similar in that they both borrow against the equity in your home, there are key differences:
|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|
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).
Is a HELOC or Home Equity Loan Better for Me?
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.
To summarize, you should consider a home equity loan if:
- You want to borrow a lump sum
- You want a fixed interest rate and fixed monthly payment
You should 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
Whatever you determine is best for you, consider how long you’ll be staying in the home and pay attention to the upfront fees in addition to the interest rate.
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.