A Comprehensive Guide To A HELOC Vs. A Home Equity Loan

If you need to borrow money to finance a major purchase, there are different ways to do it. Two of the best options that may be available for homeowners are home equity loans and home equity lines of credit. Both options let you access the equity in your home, and you can use these funds to pay down debt, finance home improvements or make a major purchase. However, a HELOC is given as a line of credit, while a home equity loan is paid out in one lump sum.

There are other differences between a HELOC and a home equity loan that may help you determine which one is better for your goals. Here’s a look at what sets them apart and the pros and cons of each option.

Home Equity Loan Vs. Line Of Credit: Defined And Explained

HELOCs and home equity loans both allow you to borrow money against the equity you’ve built in your home. Equity is the amount of your home you actually own based on the down payment and mortgage payments you’ve already made. You can calculate the amount of equity you have by taking the current value of your home and subtracting what you still owe on your mortgage.

Home equity loans and HELOCs are two ways that you can tap into your equity without selling your home. Both options can help you borrow money using your home as collateral if, for example, you want to finance renovations to increase the value of your home. These options may also be useful if you need to cover tuition costs or unforeseen medical bills. It’s crucial to keep in mind, though, that if you default, you risk losing your home through foreclosure.

Both home equity loans and HELOCs are considered second mortgages, so you’ll have two mortgage payments each month. The main differences between the two are the interest rates, how you receive the funds, and the repayment terms.

A home equity loan is an installment loan, while a HELOC is a revolving line of credit. Home equity loans come with fixed interest rates, while a HELOC typically has variable interest rates (with fixed-rate HELOCs being an exception). You’ll begin repaying the full balance of a home equity loan as soon as you receive the funds, but with a HELOC, you’ll only repay – and pay interest on – the amount that you actually spend during the draw period.

What Is A Home Equity Loan?

When you take out a home equity loan, your home is used as collateral to secure the loan. You’ll receive the funds once as a lump sum payment, and then you’ll begin repaying the loan over a fixed payment schedule.

Home equity loans typically come with a fixed interest rate – so the amount you owe each month won’t change, which makes budgeting easier. You’ll pay back the money over the course of a loan term that can range from five to 30 years.

The amount you can borrow will depend on how much equity you’ve built in your home. You can usually borrow up to 80% or 90% of the home’s appraised value minus what you owe on your mortgage.

When Should You Use A Home Equity Loan?

If you need to fund a project and have a clear idea of how much it’ll cost, you’ll probably want to apply for a home equity loan. And since a home equity loan comes with fixed rates, it’s a better choice for someone who wants to know how much their monthly payments will be.

What Is A Home Equity Line Of Credit, Or HELOC?

A HELOC also uses your home as collateral, but instead of receiving a lump sum payment, you’ll get access to an ongoing line of credit. HELOCs tend to come with variable interest rates – so the amount you owe each month can change. With a HELOC, you may also be able to borrow up to 80% or 90% of the appraised value of your home minus the amount you still owe on your mortgage.

A HELOC comes with a draw period and a repayment period. During the draw period, you can borrow as much money as you need up to the approved credit limit, and you’re typically only responsible for repaying the interest at that stage. You can potentially also begin repaying the principal so you can access the repaid funds for another project during the draw period.

The draw period often lasts for 10 years. Once the draw period is over, the repayment period begins. At this point, you’ll repay the principal and interest for the remainder of the loan term. The repayment period typically lasts 10 to 20 years.

When Should You Use A HELOC?

If you know you need to borrow money to cover an expense but aren’t sure exactly how much you’ll need, you may want to consider a HELOC. HELOCs are also a good choice for long-term projects, since you’ll have access to an ongoing line of credit. Just make sure you’re OK with the interest rates and repayment terms you receive.

Benefits And Drawbacks Of A Line Of Credit Vs. A Home Equity Loan

Understanding the pros and cons of both home equity loans and HELOCs will help you determine which financing option is best for your situation.

Home Equity Loan

Home equity loans come with both benefits and drawbacks.

Benefits

Let’s take a look at some of the advantages of taking out a home equity loan:

Drawbacks

Now, let’s go over some of the disadvantages of home equity loans:

HELOC

Likewise, there are benefits and drawbacks for home equity lines of credit.

Benefits

Here are some of the advantages of choosing a HELOC:

Drawbacks

You should also keep these downsides to HELOCs in mind:

Comparing A Home Equity Loan Vs. HELOC: At A Glance

Now that we’ve gone over the pros and cons of each option, let’s review the key differences between home equity loans and HELOCs.

How To Acquire A Home Equity Loan Or HELOC

If you think that a home equity loan or HELOC could be right for you, here are the steps you can take to get one.

1. Fulfill The Application Requirements

Different lenders have varying requirements for financing, so it’s a good idea to compare your options among several different lenders. Understanding the different credit requirements will help you determine which loan may be right for you. The following chart outlines the differences and similarities between the requirements for a home equity loan and the qualifications to get a HELOC:

Home Equity

Lenders require that you have a minimum amount of equity in your home before you can use it to take out a home equity loan or HELOC. You’ll typically need to have paid off at least 15% to 20% of your home’s total value.

Credit Score

To qualify for a home equity loan or HELOC, you’ll need a minimum credit score of 620 to 680, depending on which loan you get. However, if you want to qualify for the best rates and terms, you’ll want to have good to excellent credit.

Lenders use your credit score to determine how good you are at handling debt. If you barely meet the minimum credit requirements, your lender will either deny you the loan or give you higher interest rates to compensate. 

Debt-To-Income Ratio

In addition to good credit, you’ll also need a maximum debt-to-income ratio of 43%. Your DTI ratio measures the percentage of your gross monthly income that is going toward debt payments. A DTI ratio above 43% indicates that you may be overextended financially and not a good candidate for a second mortgage. 

Loan Term

The terms for a home equity loan start at five years and can be extended for as long as 30 years, while a HELOC often has a draw period of 10 years, followed by a repayment period of 10 or 20 years.

With a home equity loan, you’ll begin repaying the loan as soon as you receive the funds. With a HELOC, you’re typically only responsible for making interest payments during the draw period. Once you reach the repayment period, you’ll begin paying off the line of credit.

Loan Amount

The amount of money you receive for a HELOC or home equity loan depends on how much equity you’ve built up in your home. Most lenders will let you borrow up to 80% or even 90% of the appraised value of your home, minus the outstanding balance on your mortgage.

Interest Rates

When you’re comparing a HELOC versus a home equity loan, the rates are one of the biggest differences. Home equity loans are secured loans with fixed interest rates, so your monthly payments will stay the same over the life of the loan. HELOCs are also considered secured loans, but they typically come with variable interest rates subject to market fluctuations. That means they could rise.

2. Gather Financial Documents

Before a lender can approve you for a home equity loan or HELOC, they’ll first need to see some proof that you can afford to repay it. You can expect to be asked to provide the following financial documents:

3. Submit Your Application

Before you apply for a home equity loan, you need to determine how much you’ll need to borrow. It’s also a good idea to shop around for quotes. Remember, you don’t have to take out a home equity loan with the same lender who issued your primary mortgage. Once you’ve picked the lender you want to work with, they will be able to guide you through the process of submitting a formal loan application.

4. Have Your Home Appraised

The amount of equity you have in your home partly depends on how much it’s currently worth. That means that in order to determine how much you can borrow, your lender will need to know the current market value of the home. To determine how much your home is worth, you’ll need to have a home appraisal performed by a licensed, third-party professional. The appraiser will examine your home and compare it to similar homes in the area that have recently been sold to determine its fair market value.

Let’s say your lender is willing to let you borrow up to 90% of your home’s current value. Suppose your home is appraised at $450,000, and you still owe $105,000 on your mortgage. If you multiply the value of the home by 0.90, you’ll get:

$450,000 x 0.90 = $405,000

Then, subtract the amount you still owe on your mortgage:

$405,000 – $105,000 = $300,000

This tells you that you could borrow up to $300,000 with a home equity loan or HELOC.

5. Pay Closing Costs

Just like you did when you took out your mortgage, you’ll need to pay closing costs to take out a home equity loan or HELOC. Keep in mind that closing costs can add up to 2% to 6% of the total loan amount. This includes the cost of the appraisal, origination fee, title insurance, and other fees. So, if you’re taking out a $150,000 home equity loan, you can expect to pay anywhere from $3,000 to $9,000 in closing costs.

6. Access Your Home Equity Funds

You’ll receive the funds from your home equity loan as one lump sum payment after you close on the loan. The amount of time it takes to receive the funds will depend on your lender and the method of payment. With a HELOC, you’ll be able to use your line of credit until the draw period closes. In general, you can expect the process of taking out either loan option to take two weeks to two months.

How To Decide Which Is Right For You: Home Equity Line Of Credit Vs. Loan

If you’re trying to decide between a home equity loan and a line of credit, there are several things to consider. First, you should consider what you’ll use the funds for and how much money you need. Which type of financing will help you reach your long-term goals and stay within your budget?

“It really depends on what you need the money for,” says Alex Shekhtman, CEO and Founder of LBC Mortgage in North Hollywood, California. “If you need a big lump sum – say, for a major renovation or to consolidate debt – a home equity loan is the way to go. It gives you a fixed rate and predictable payments, which is great for budgeting. On the other hand, if you want access to cash over time, like for ongoing projects or unpredictable expenses, a HELOC is better because you can borrow as you need it.”

The Bottom Line

Home equity loans and home equity lines of credit are two ways you can use the equity in your home to borrow money. You can use the money you borrow to finance whatever you need, and you’ll pay a lower interest rate than you would for other types of loans. However, keep in mind that you’ll be taking on a second mortgage and will owe another payment each month. Make sure that you’ll be able to keep up, or you could risk losing your home.

Jamie Johnson contributed to the reporting of this article.