Home Equity Loan vs. Line of Credit: Understanding the Differences
As housing prices remain steady in many regions across the U.S., homeowners are increasingly looking at their home equity as a financial resource.
Whether for home improvements, debt consolidation, or major expenses, tapping into your home equity can be a smart move when done wisely. Two of the most popular options are home equity loans and home equity lines of credit (HELOCs).
While both rely on the value of your home as collateral, they serve different purposes and come with unique benefits and risks.
In this article, we’ll break down the differences between these options, discuss their pros and cons, and help you decide which might be the best fit for your financial needs.
What Is a Home Equity Loan?
A home equity loan, often referred to as a “second mortgage,” allows homeowners to borrow a lump sum of money against the equity they’ve built in their property. This type of loan typically comes with a fixed interest rate and a set repayment term, making it predictable and easy to budget for.
Key Features of a Home Equity Loan:
- Lump-sum disbursement
- Fixed interest rates
- Fixed monthly payments over a specific term
Pros:
- Predictability: Fixed rates and payments make it easier to manage your budget.
- Ideal for large projects: Great for one-time expenses, like home renovations or consolidating high-interest debt.
- Lower rates than personal loans: Home equity loans often have lower interest rates than unsecured loans.
Cons:
- Risk of foreclosure: Missing payments could put your home at risk.
- Upfront costs: May include closing costs and fees.
What Is a Home Equity Line of Credit (HELOC)?
A HELOC functions more like a credit card, offering a revolving line of credit that you can draw from as needed. HELOCs usually have variable interest rates and a draw period (often 10 years), during which you can borrow funds, followed by a repayment period.
Key Features of a HELOC:
- Access funds as needed
- Variable interest rates (in most cases)
- Interest-only payments during the draw period
Pros:
- Flexibility: Borrow only what you need when you need it.
- Potential for lower initial payments: Interest-only payments during the draw period can reduce monthly costs.
- Useful for ongoing expenses: Ideal for projects or needs that come in phases, like ongoing medical bills or home upgrades.
Cons:
- Rate fluctuations: Variable rates can make payments unpredictable.
- Risk of over-borrowing: Easy access to funds could lead to excessive debt.
- Conversion to repayment: After the draw period ends, repayment terms can increase monthly costs significantly.
Home Equity Loan vs. HELOC: Key Differences at a Glance
| Feature | Home Equity Loan | HELOC |
|---|---|---|
| Disbursement | Lump sum | As needed (revolving credit) |
| Interest Rate | Fixed | Variable (often) |
| Repayment | Fixed monthly payments | Interest-only during draw, then full repayment |
| Best For | Large, one-time expenses | Ongoing or phased expenses |
| Predictability | High | Low (due to variable rates) |
Who Benefits Most from Each Option?
When to Choose a Home Equity Loan:
- You need a specific amount of money for a large, one-time expense.
- You prefer predictable payments and are wary of variable interest rates.
- You want to lock in a low rate while rates are favorable.
When to Choose a HELOC:
- You anticipate ongoing or phased expenses.
- You want flexibility in how much you borrow and when.
- You’re comfortable with the potential for fluctuating payments due to variable interest rates.
Current Trends in Home Equity Lending
As of 2024, rising interest rates have made borrowers more cautious about variable-rate products like HELOCs. According to Freddie Mac, the average interest rate on 30-year fixed mortgages reached 6.8%, leading some homeowners to consider home equity loans over refinancing their first mortgage.
“Home equity loans are becoming more appealing because they offer stability in an unpredictable market,” says Sarah Mitchell, Senior Loan Advisor at Prime Equity Lending. “Homeowners like knowing their rate won’t change, even if the Federal Reserve raises rates again.”
Additionally, the U.S. Census Bureau reports that the average homeowner holds over $274,000 in home equity, highlighting the significant financial potential available to many households. With this in mind, understanding the best way to access your equity is more important than ever.
Real-World Example of Costs
To better illustrate the financial differences between a home equity loan and a HELOC, let’s consider the following example:
| Loan Type | Amount Borrowed | Interest Rate | Monthly Payment | Total Interest Paid Over 10 Years |
|---|---|---|---|---|
| Home Equity Loan | $50,000 | 7% (fixed) | $580 | $19,600 |
| HELOC (Interest-Only) | $50,000 | 6% (variable) | $250 (draw period) | Varies based on rate changes |
This comparison underscores the predictability of a home equity loan versus the initial affordability of a HELOC.
Risks and Considerations
Both home equity loans and HELOCs come with risks. Since your home serves as collateral, failure to repay either type of loan could result in foreclosure. Additionally, consider the following:
- Market Volatility: Variable rates on HELOCs could rise significantly, increasing monthly payments.
- Over-Borrowing: Easy access to funds with a HELOC can lead to overspending and long-term financial strain.
- Loan-to-Value Ratio (LTV): Most lenders require you to maintain an LTV below 80%, limiting how much equity you can access.
When to Avoid Tapping Into Home Equity
While accessing your home equity can be a smart financial move, it’s not always the right choice. Avoid borrowing against your home equity if:
- You lack a stable income or emergency savings.
- You plan to sell your home soon, which could complicate repayment.
- You’re considering using the funds for non-essential expenses, like vacations or luxury purchases.
The Bottom Line
Deciding between a home equity loan and a line of credit depends on your financial goals and circumstances. A home equity loan provides a lump sum with predictable payments, ideal for major projects or consolidating debt.
A HELOC offers flexibility for ongoing expenses, like renovations or tuition. Both options leverage your home’s equity but come with risks, such as the potential loss of your property if payments aren’t made. Evaluate your needs, repayment ability, and long-term goals carefully.
Consulting a financial advisor can help you make the most informed choice and maximize the benefits of your home’s equity.
Frequently Asked Questions
Can I switch from a HELOC to a home equity loan?
Yes, many lenders allow borrowers to convert a HELOC to a fixed-rate home equity loan, often during the repayment phase.
What happens if I sell my home before repaying a home equity loan or HELOC?
The outstanding balance must be paid in full at closing, which can reduce your net proceeds.
Are there tax benefits to using a home equity loan or HELOC?
Interest may be tax-deductible if the funds are used for home improvements, but consult a tax advisor for specifics.
What’s the minimum credit score for qualifying?
Most lenders require a score of 620 or higher, but requirements vary.
Can I have both a home equity loan and a HELOC?
Yes, if you have enough equity and meet the lender’s requirements, you can use both simultaneously.
Are home equity products available for investment properties?
Typically, home equity loans and HELOCs are reserved for primary residences, but some lenders may allow them for investment properties.
Do HELOC rates ever become fixed?
Some HELOCs offer fixed-rate options for portions of the borrowed amount.
What’s the difference between refinancing and a home equity loan?
Refinancing replaces your primary mortgage with a new one, while a home equity loan is a second loan using your home as collateral.