HELOC Vs. Home Equity Loan: How Do They Work? | Bankrate

Home equity lines of credit (HELOCs) and home equity loans are loans that use your home as collateral, and both can be great for borrowing money if you’ve paid down a significant portion of your mortgage. A HELOC is a line of credit that allows you to borrow money as needed with a variable interest rate, while a home equity loan is a lump sum that is disbursed upfront and paid back in fixed installments.

Most home equity loans and HELOCs allow you to borrow up to 85 percent of the value of your home, minus your outstanding mortgage balance. These financial options tend to have low interest rates and fair terms because they use your home as collateral. Before you settle on a home equity loan or line of credit, shop around to find an option with the lowest fees — or no fees if possible.

What are the differences between a HELOC and home equity loan?

If you have equity in your home and want to borrow money, you may choose a HELOC or home equity loan. Below are some of the major differences between these options.

Home equity loan
HELOC

Interest rates
Fixed
Variable

Monthly payments
Same every month
Changes over time

Disbursement of funds
Upfront lump sum
As needed

Repayment terms
Starts as soon as the loan is disbursed
Interest-only payments during draw period; repay principal and interest afterward

What is a home equity line of credit?

A home equity loan is a secured loan that lets you borrow against your home equity with a fixed interest rate and repayment term. Your interest rate depends on your credit score, payment history, loan amount and income. If your credit improves after you’ve obtained a home equity loan, you might be able to refinance to a lower interest rate.

How you use home equity loan money is up to you. Some use it to pay for major repairs or renovations, like adding a new room, gutting and remodeling a kitchen or updating a bathroom. You can also take out a home equity loan with a low, fixed-rate to pay off high-interest credit card debt.

Pros

You’ll get a fixed interest rate and predictable monthly payment.
The loan proceeds are disbursed to you at closing and can be used however you see fit.
Some lenders don’t charge origination fees.
The interest paid on the loan may be tax deductible if the proceeds are used to upgrade your home

Cons

The best home equity loan rates and terms go to consumers with good or excellent credit, or a FICO score of 670 and up, which means you could get unfavorable loan terms with a lower credit score.
You need a lot of home equity to qualify — usually 15 percent to 20 percent or more.
If property values decline, you might be upside down on your mortgage, meaning you owe more than your home is worth.
You could lose your home if you fall behind on the loan payments.

If you have a specific project in mind and know exactly how much it will cost, a home equity loan can be a smart choice as it can provide you with a lump sum of cash. Just make sure you don’t plan to borrow more money soon.

How do I choose between a home equity loan and a HELOC?

A home equity loan could be better if:

You know the cost of your project and need to borrow a lump sum of money.
You prefer a fixed interest rate that will never change.
A fixed monthly payment works best for your budget.
You want to consolidate high-interest credit card debt at a lower interest rate.

A HELOC could be better if:

You want to borrow as little or as much as you want, when you want.
You have upcoming expenses such as college tuition and don’t want to borrow until you’re ready.
You don’t mind if your payment fluctuates.

How do you get a HELOC or home equity loan?

While eligibility requirements for home equity products may have tightened up as a result of the coronavirus pandemic, there are still options available for eligible borrowers:

Considerable equity in your home: You’ll likely need to have at least 20 percent equity in your home, or an 80 percent loan-to-value ratio, meaning your mortgage balance and any existing home equity loans total no more than 80 percent of your home’s value.
Good credit: Although lender requirements vary, in general, you’ll want to have a credit score in the mid-600s to qualify and a score above 700 to get the best interest rates and terms. Some lenders also require a higher credit score for higher loan amounts.
Low debt: Many home equity lenders require a debt-to-income ratio of 43 percent or below. This means your monthly debt payments make up no more than 43 percent of your gross monthly income.
Sufficient income: You need to prove you can repay your loan, although most lenders don’t disclose their income thresholds.
Reliable payment history: A long history of on-time payments on other bills can help you qualify for a home equity loan or a HELOC. A history of late payments makes it harder to qualify.

Can you have a HELOC and a home equity loan?

Theoretically, there is no limit to the number of home equity loans or lines of credit you can hold simultaneously. But it’ll be harder to qualify with each new application because you’ll have less and less equity to tap with each loan.

For instance, if you have a home valued at $500,000 and two home equity loans totaling $425,000, you’ve already borrowed 85 percent of your home’s value — the cap for many home equity lenders.

Lenders may also charge higher interest rates on additional loans or lines of credit, especially if you ask for a second loan from the same lender.

How does the Fed rate increase impact home equity products?

Lenders often base home equity product rates on the prime rate, which is generally three percentage points higher than the fed funds rate. Consequently, recent rate hikes have resulted in more costly home equity loans and HELOCs.

Borrowers seeking home equity loans have some form of certainty regarding borrowing costs because interest rates on these products are generally fixed. However, this is not the case with HELOCs, as they come with variable interest rates, and monthly payments could continue to rise with subsequent Fed rate hikes.

Bottom line

Home equity loans and home equity lines of credit can allow you to borrow money against your home equity. But they’re not the same. Before you decide which option is best for you, consider the purpose of the funds, how much you need, and whether or not you’ll want to borrow more in the future. Once you decide, get your credit in good shape and shop around to secure the best rate.