HELOC (Home Equity Line of Credit) and Home Equity Loan: Comparing Your Options

Both let you borrow money against the equity in your home, but they work in different ways

Reviewed by Katie MillerFact checked by Yarilet PerezReviewed by Katie MillerFact checked by Yarilet Perez

One of the biggest perks of homeownership is the ability to build equity over time. You can use your equity to secure low-cost funds in the form of a second mortgage—either a one-time home equity loan or a revolving home equity line of credit (HELOC). There are advantages and disadvantages to each of these types of credit, so it’s important to understand how they work before you proceed. You may also have other options that are worth exploring.

Key Takeaways

• If you have equity built up in your home, you may be eligible for a home equity loan or home equity line of credit (HELOC).
• Because home equity loans and HELOCs are secured by the value of your home, lenders are willing to offer lower interest rates than for some other types of loans.
• A home equity loan comes as a lump sum of cash, often with a fixed interest rate.
• A home equity line of credit (HELOC) is a revolving source of funds, much like a credit card, that you can access as you choose.

HELOCs and Home Equity Loans: The Basics

Home equity loans and HELOCs both use the equity in your home—that is, the difference between your home’s current value and how much you still owe on your mortgage—as collateral. Because they are secured by that collateral, lenders are willing to offer home equity loans at very competitive interest rates—usually close to those of first mortgages. Compared with unsecured borrowing sources, such as credit cards, you’ll be paying less in financing fees for the same loan amount.

However, there’s a significant downside to using your home as collateral. As with a first mortgage, lenders will place a lien on your home, giving them the right to seize and sell it if you fail to make payments. The more you borrow against your house or condo, the more you’re putting yourself at risk.

HELOC and Home Equity Loan Pros and Cons

As with any type of borrowing, HELOCs and home equity loans have upsides and downsides.

Pros

• Lower cost than many other types of loans

• The ability to borrow a relatively large amount of cash

• Potential tax breaks if you use the funds on the home

Cons

• Because your home serves at collateral you’re at risk of foreclosure if you default

• If the real estate market takes a dip, having too much debt could put you “underwater,” meaning you owe more than the home is worth

How Much Can You Borrow?

Banks underwrite second mortgages much like other home loans. They have guidelines that dictate how much they will lend (and whether they will offer you a loan at all), based on the value of your property and your creditworthiness.

In making their determination, lenders will calculate a combined loan-to-value (CLTV) ratio. That ratio measures the value of all the loans that secure the home, including first and second mortgages, against what the home is worth.

Here’s an example. Suppose you’re working with a bank offering a maximum CLTV ratio of 80%, and your home is worth $300,000. If you currently owe $150,000 on your first mortgage, you may qualify to borrow an additional $90,000 in the form of a home equity loan or HELOC. The calculation is $300,000 x 0.80 = $240,000 – $150,000 = $90,000.

Here is more about how home equity loans and HELOCs work:

How Home Equity Loans Work

A home equity loan comes as a lump sum of cash. It can be a good option if you need the money for a one-time expense, such as a kitchen renovation or a wedding. These loans usually offer fixed rates, so you know precisely what your monthly payments will be when you take one out.

Home equity loans usually aren’t the answer if you only need a small infusion of cash. Though some lenders will extend loans for $10,000, many won’t give you one for less than $35,000. What’s more, you have to pay many of the same closing costs associated with a first mortgage, such as loan-processing fees, origination fees, appraisal fees, and recording fees.

Lenders may also require you to pay points—that is, prepaid interest—at closing time. Each point is equal to 1% of the loan value. So on a $100,000 loan, one point would cost you $1,000.

Points lower your interest rate, which might actually help you in the long run. Still, if you’re thinking about paying off the loan early, that upfront interest doesn’t work in your favor. If you think that might be the case, you can often negotiate with your lender for fewer or even no points.

Note

Eligibility for a home equity loan or HELOC also depends on your employment history, income, and credit score. The higher your score, the lower your interest rate may be.

How HELOCs Work

HELOCs work differently from home equity loans. They are a revolving source of funds, much like a credit card, that you can borrow from as you choose as long as you don’t exceed your assigned credit limit.

Most lenders offer a number of ways to access those funds, whether it’s through an online transfer, writing a check, or using a credit card linked to your account. Unlike home equity loans, HELOCs tend to have few, if any, closing costs, and they usually feature variable interest rates—though some lenders offer fixed rates for a certain number of years.

There are pros and cons to the flexibility that these loans offer. On the plus side, you can borrow against your credit line at any time, and you won’t owe interest on the untapped funds. In that way, it can be a useful source of ready cash in an emergency, such as if you lose your job or face a big medical bill (as long as your bank doesn’t require any minimum withdrawals before then).

The biggest downside, again, is that your home serves as collateral for a HELOC. If you’re unable to repay it for any reason, you risk losing the home to foreclosure.

HELOC Draw and Repayment Periods

Most home equity credit lines have two phases. First is a draw period, often 10 years, during which you can access your available credit as you choose. Typically, HELOC contracts only require you to make small, interest-only payments during the draw period, though you may have the option to pay extra and have it go toward the principal.

After the draw period ends, you can sometimes ask for an extension. Otherwise, the loan enters the second phase, repayment. From here on out, you can no longer access additional funds and you must make regular principal-plus-interest payments until the balance is paid down to zero. Most lenders have a 20-year repayment period after a 10-year draw period.

Once the repayment period begins, your required payments can almost double. For example, payments on an $80,000 HELOC with a 7% annual percentage rate (APR) would run about around $470 a month during the first 10 years when only interest payments are required, then shoot up to around $720 a month when repayment kicks in.

That can result in payment shock for many unprepared HELOC borrowers and even lead to default and foreclosure if the borrower can’t afford the new payments.

Home Equity Loans and HELOCs vs. Refinancing

Second mortgages aren’t the only way to tap the equity in your home and obtain some extra cash. You can also do what’s known as a cash-out refinance, in which you take out a new and larger loan to replace the original mortgage. After paying off the old loan, you can use the remaining cash for whatever purposes you have in mind.

Refinancing does have certain advantages over a second mortgage. The interest rate is generally a bit lower than that of home equity loans and if rates have dropped overall since you took out your old loan, you’ll want your new primary mortgage to reflect that.

Refinances have drawbacks, too. You’re taking out a new first mortgage, so closing costs tend to be much higher than with HELOCs. And if refinancing means you’ll have less than 20% equity in your home, you may also have to pay private mortgage insurance (PMI) premiums. PMI can usually be canceled when a borrower reaches 20% home equity.

It wouldn’t hurt to have a loan officer run the numbers for each option, so you can decide which one might be better in your situation.

Important

Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report with the Consumer Financial Protection Bureau or the U.S. Department of Housing and Urban Development (HUD).

Getting a Home Equity Loan or HELOC

Loans can vary significantly from one lender to the next, so it pays to shop around. In addition to traditional banks, you can also reach out to savings and loans, credit unions, and mortgage companies.

Though it’s extra work, don’t talk to just one lender. Most borrowers should get at least three quotes. You might want to start with any bank or other financial institution where you already have an account. Ask if it has special rates or other incentives for existing customers.

Another option is to use a mortgage broker. They have relationships with multiple lenders and get paid by the lender you ultimately choose.

For loans under $100,000, a small community bank or credit union may offer the best deal. For larger loans ($150,000 or more), talk to local and national banks along with mortgage brokers.

Don’t focus solely on interest rates. Also ask about closing fees and any other costs in order to make a fair comparison.

Negotiating for Lower Fees

Many of the fees a lender may try to charge aren’t set in stone. Some lenders, for example, are willing to bend on origination fees, which cover the commission paid to the loan officer or broker. If they require you to pay points on your loan, they may be willing to haggle on that, too. But you have to ask.

In general, you’ll get the best terms if you have a history of steady employment and a strong credit score. As with any mortgage application, it’s a good idea to check your credit reports ahead of time and make sure they’re free of errors that could hurt you. By law you’re entitled to a free copy of your credit report at least once a year from each of the three major credit bureaus, Equifax, Experian, and TransUnion. The official website for that purpose is AnnualCreditReport.com.

Warning

Criminals have been known to apply for HELOCs in other people’s names or hack into borrowers’ existing HELOCs and siphon out funds. To guard against HELOC fraud, check your credit reports regularly for any accounts you don’t recognize and, if you have a HELOC, review your account statements carefully.

If You Can’t Pay Back Your Loan or HELOC

If, for whatever reason, you find that you can’t pay back your home equity loan or line of credit, it isn’t a foregone conclusion that you will lose your home. However, even if you avoid losing your home, you will face serious financial consequences.

Most mortgage lenders will work with borrowers who are struggling to make payments. But it’s important to contact your lender as soon as possible. The last thing you should do is ignore the problem and allow it to become worse.

Some lenders will offer certain borrowers a modification of their home equity loan or line of credit. Modifications can include adjustments to the term or length of the loan, the interest rate, the monthly payments, or some combination of those. Bear in mind that extending the term of the loan will lower your monthly payments, but it may mean paying more in the end.

What Can You Use a Home Equity Loan or HELOC For?

You can use a home equity loan or HELOC for basically any purpose you choose. From a financial planning standpoint, one of the best uses of the funds is for renovations and remodeling projects that will increase the value of your home. This way, you may increase available equity in your home while making it more livable. In some cases, you may also be eligible for a tax deduction (see next section).

You can also use the money to pay off high-interest debt, such as credit card balances. While such uses aren’t eligible for a tax deduction, the money you save may be more than worth it.

Is Home Equity Loan or HELOC Interest Tax-Deductible?

Under current tax law you can you write off at least a portion of the interest on home equity credit as long as you itemize deductions and meet certain other requirements.

Currently, couples who file jointly can deduct the interest on up to $750,000 of eligible mortgage debt, including home equity loans and HELOCs (or up to $375,000 if you file separately) as long as the debt is used to “buy, build, or substantially improve” the home against which it was secured. These rules run through the end of 2025 and may change in the future.

Can You Back Out of a Home Equity Loan or HELOC?

Yes, if you act very quickly. There’s a federally mandated three-day cancellation rule, know as the right of rescission, that applies to both home equity loans and HELOCs, but you have to notify the lender in writing. That notice has to be mailed or filed electronically by midnight of the third day (not including Sundays).

The Bottom Line

There may come a time in your life when access to extra cash becomes a necessity. If so, a home equity loan or HELOC could be your best option. While many consumers use these forms of credit without incident, it’s worth knowing that there are also risks involved before you apply.

Read the original article on Investopedia.