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

Home Equity Loan vs. HELOC: An Overview

Home equity loans and home equity lines of credit (HELOCs) are loans that are secured by a borrower’s home. A borrower can take out an equity loan or credit line if they have equity in their home. Equity is the difference between what is owed on the mortgage loan and the home’s current market value. In other words, if a borrower has paid down their mortgage loan to the point that the value of the home exceeds the outstanding loan balance, the borrower can borrow a percentage of that difference or equity, generally up to 85% of a borrower’s equity.

Because both home equity loans and HELOCs use your home as collateral, they usually have much better interest terms than personal loans, credit cards, and other unsecured debt. This makes both options extremely attractive. However, consumers should be cautious of utilizing either. Racking up credit card debt can cost you thousands in interest if you can’t pay it off, but becoming unable to pay off your HELOC or home equity loan can result in losing your home.

Home equity loans give the borrower a lump sum up front, and in return, they must make fixed payments over the life of the loan. Home equity loans also have fixed interest rates. Conversely, HELOCs allow a borrower to tap into their equity as needed up to a certain preset credit limit. HELOCs have a variable interest rate, and the payments are not usually fixed.

Both home equity loans and HELOCs allow consumers to gain access to funds that they can use for various purposes, including consolidating debt and making home improvements. However, there are distinct differences between home equity loans and HELOCs.

Home Equity Loan

A home equity loan is a fixed-term loan granted by a lender to a borrower based on the equity in their home. Home equity loans are often referred to as second mortgages. Borrowers apply for a set amount that they need, and if approved, receive that amount in a lump sum up front. The home equity loan has a fixed interest rate and a schedule of fixed payments for the term of the loan. A home equity loan is also called a home equity installment loan or an equity loan.

Loan collateral and terms

The equity in your home serves as collateral, which is why it’s called a second mortgage and works similarly to a conventional fixed-rate mortgage. However, there needs to be enough equity in the home, meaning that the first mortgage needs to be paid down by enough to qualify the borrower for a home equity loan.

The loan amount is based on several factors, including the combined loan-to-value (CLTV) ratio. Typically, the loan amount can be 80% to 90% of the property’s appraised value. Other factors that go into the lender’s credit decision include whether the borrower has a good credit history, meaning that they haven’t been past due on their payments for other credit products, including the first mortgage loan. Lenders may check a borrower’s credit score, which is a numerical representation of a borrower’s creditworthiness.

Payments and interest rate

A home equity loan’s interest rate is fixed, meaning that the rate doesn’t change over the years. Also, the payments are fixed, equal amounts over the life of the loan. A portion of each payment goes to interest and the principal amount of the loan. Typically, the term of an equity loan term can be anywhere from five to 30 years, but the length of the term must be approved by the lender. Whatever the period, borrowers will have stable, predictable monthly payments to make for the life of the equity loan.

Home Equity Line of Credit (HELOC)

A HELOC is a revolving credit line. It allows the borrower to take out money against the credit line up to a preset limit, make payments, and then take out money again.

With a home equity loan, the borrower receives the loan proceeds all at once, while a HELOC allows a borrower to tap into the line as needed. The line of credit remains open until its term ends. Because the amount borrowed can change , the borrower’s minimum payments can also change, depending on the credit line’s usage.

Loan collateral and terms

Like an equity loan, HELOCs are secured by the equity in your home. Although a HELOC shares similar characteristics with a credit card because both are revolving credit lines, a HELOC is secured by an asset (your house), while credit cards are unsecured. In other words, if you stop making your payments on the HELOC, sending you into default, you could lose your home.

A HELOC has a variable interest rate, meaning the rate can increase or decrease over the years. As a result, the minimum payment can increase as rates rise. However, some lenders offer a fixed rate of interest for home equity lines of credit. Also, the rate offered by the lender—just as with a home equity loan—depends on your creditworthiness and how much you’re borrowing.

Draw and repayment periods

HELOC terms have two parts. The first is a draw period, while the second is a repayment period. The draw period, during which you can withdraw funds, might last 10 years, and the repayment period might last another 20 years, making the HELOC a 30-year loan. When the draw period ends, you cannot borrow any more money.

During the HELOC’s draw period, you still have to make payments, which are typically interest-only. As a result, the payments during the draw period tend to be small. However, the payments become substantially higher over the course of the repayment period because the principal amount borrowed is now included in the payment schedule along with the interest.

It’s important to note that the transition from interest-only payments to full, principal-and-interest payments can be quite a shock, and borrowers need to budget for those increased monthly payments.

Key Differences

HELOCs can be useful as a home improvement loan because they allow you the flexibility to borrow as much or as little as you need. If it turns out that you need more money, you can get it from your line of credit—assuming there’s still availability—without having to reapply for another mortgage loan.

You should ask yourself one question: What’s the purpose of the loan? A home equity loan is a good choice if you know exactly how much you need to borrow and how you want to spend the money. When approved, you’re guaranteed a certain amount, which you receive in full when the loan is advanced. As a result, home equity loans can help with big expenses such as paying for a children’s college fund, remodeling, or debt consolidation.

Conversely, a HELOC is a good choice if you aren’t sure how much you’ll need to borrow or when you’ll need it. Generally, it gives you ongoing access to cash for a set period—sometimes up to 10 years. You can borrow against your line, repay it all or in part, then borrow that money again later, as long as you’re still in the HELOC’s draw period.

However, an equity line of credit is revocable—just like a credit card. If your financial situation worsens or your home’s market value declines, then your lender could decide to lower or close your credit line. So, although the idea behind a HELOC is that you can draw upon the funds as you need them, your ability to access that money isn’t a sure thing.

Special Considerations

It’s important to note that obtaining a HELOC may be tougher in 2021: In 2020, two major banks—Wells Fargo and JPMorgan Chase—put a freeze on new HELOCs as a consequence of the coronavirus pandemic. Other banks could put a lock on credit in the future.

There was initially some confusion about whether homeowners would be able to deduct the interest from their home equity loans and HELOCs on their tax returns following the passage of the Tax Cuts and Jobs Act (TCJA). Unlike before the law, homeowners can’t deduct interest for home equity loans and HELOCs unless the funds are used to “buy, build, or substantially improve” your home, and the money that you spend on such improvements must be spent on the property that serves as equity for the loan.

In other words, you can no longer deduct interest from these loans if you use the money to pay for your child’s college or to eliminate debt. The law applies to tax years through 2025. Deductions are limited to the interest on qualified loans of $750,000 or less ($375,000 for someone who is married filing separately). There are additional rules, especially if you also have a first mortgage, so be sure to check with a tax expert before using this deduction.

The Bottom Line

Keep in mind that just because you can borrow against your home’s equity doesn’t mean you should. But if you need to, there are many factors to consider when deciding which is the best way to borrow: how you will use the money, what might happen to interest rates, your long-term financial plans, and your tolerance for risk and fluctuating rates.

Some people aren’t comfortable with the HELOC’s variable interest rate and prefer the home equity loan for the stability and predictability of fixed payments and knowing how much they owe.

However, if you’re uncertain about the amount needed and you’re comfortable with the variable interest rate, then a HELOC might be your best bet. As with any credit product, it’s important not to get overextended and borrow more than you can pay back because your home is the collateral for the loan.