Loan amounts for HELOC and home equity loans are based on equity, loan-to-value ratio, and credit worthiness
You need an appraisal to get either a HELOC or home equity loan
HELOCs and home equity loans have different interest rates and disbursement and repayment methods
If you can’t repay the loan, then the lender can foreclose on your house
Homeowners who have paid off all or most their mortgage can actually borrow money against the value of their house with a second mortgage. There are two types of second mortgages: a home equity line of credit (HELOC) and a home equity loan. Both will let you borrow money while your house serves as collateral — meaning that if you can’t repay the loan, the lender can foreclose on your house.
The loan amounts for both HELOCs and home equity loans depend on the appraised value of your home, how much of your mortgage you’ve paid off — most lenders set a limit to 85% of your home equity, so most people cannot borrow the entire face value of their home — as well as your financial standing, like your credit score. The money that you borrow will accrue interest, but the rate may be fixed or variable depending on whether you choose a HELOC or home equity loan. Other major differences include how you receive the funds and how you repay the loan.
HELOC and home equity loans offer homeowners a way to access a large amount of money that they can use for whatever purpose, including home improvements, paying for college, or consolidating debts. You may also be able to claim a mortgage interest tax deduction with either. However, HELOC and home equity loans have their downsides as well, since homeowners are essentially taking on a second form of debt that’s attached to the home. If you’re considering a second mortgage, we’ll discuss the differences between these two types and which one might be better for you.
In this article:
HELOC vs home equity loan
The chart below shows the different features of a HELOC vs home equity loan at a glance.
|HELOC||Home equity loan|
|Loan amount||Based on equity and credit score||Based on equity and credit score|
|Disbursement method||Draw money as needed||Lump sum payment|
|Minimum withdrawal||May be required||N/A|
|Interest rates||Variable rate||Fixed rate|
|Repayment amount||Varies by rate and loan amount||Fixed monthly payment|
|Prepayment fee||Depends on lender||Depends on lender|
|Deductible interest||Interest may be tax-deductible||Interest may be tax-deductible|
|Closing costs||Origination fees, appraisal fees, etc.||Origination fees, appraisal fees, etc.|
|Other fees||Annual fees, transaction fees||N/A|
How a HELOC works
A HELOC functions similarly to a credit card since it is a type of revolving credit in which you only borrow and use as much money as you need. The lender will determine a spending limit, or maximum line amount, which you can continue to access as long as your account is open and you haven’t gone over that credit limit. Once your HELOC has been approved, the lender might issue checks or a credit card for you to use.
To determine your credit limit, the lender considers your ability to pay back the loan. They’ll look at the usual financial indicators, like income, debt-to-income ratio (how much you make versus any outstanding debt), credit score, and credit history among other factors.
Most HELOCs have an adjustable interest rate, which fluctuates over the course of the loan and is based on economic factors and indexes. Be careful of whether or not a low interest rate is actually just an introductory or promotional rate that might expire in a few months. You may be able to secure a HELOC with a fixed rate, though it’s usually less common. However, some lenders may allow you to withdraw a portion of funds through the HELOC at a fixed rate under certain conditions.
A HELOC consists of two phases. During the draw period, the credit line is open and you can access the money. Five to 10 years is standard. After the draw period closes, you typically won’t be able to make withdrawals as you enter into the repayment period, when you have to repay the remaining balance.
Repaying a HELOC
How you repay the loan will vary depending on the lender and terms of your loan agreement.
Borrowers of a HELOC might make (small) payments during the draw period on just the interest, followed by higher payments (on the principal and interest) during the repayment period. Another repayment schedule might consist of monthly payments of both the principal and interest during the draw period, and then a very large payment (sometimes referred to as a balloon payment) for the remaining loan balance once the draw period ends.
If you wanted to get ahead of your payments and repay the loan more quickly, you might be able to prepay or pay more than the required minimum payments.
You may not be able to know exactly your projected payments, since rates are subject to change, but make sure you understand the repayment terms and talk to the lender about what you can expect.
While HELOCs may operate like credit cards, they are still considered type of mortgage and come with the very same closing costs associated with a traditional mortgage, including e origination fees, appraisal fees, and application fees. However, lenders often waive these fees.
Additionally, HELOCs have other costs, like annual fees and transaction fees, charged every time you withdraw funds. You may also have to pay fees and penalties for not using the HELOC, making prepayments, or closing the line of credit early before the draw period officially ends. Always talk with your lender about the fees and see if you can negotiate them.
How a home equity loan works
With a home equity loan, the borrower receives the money as a lump sum payment. The loan term lasts typically up to 30 years (like a traditional mortgage).
The interest rates for a home equity loan are fixed, so they won’t change, but they might also be higher than the variable rate that comes with a HELOC.
Repayment for a home equity loan begins shortly after you receive the money. The loan balance accrues interest and you will make a fixed monthly payment amount everything is paid off. Sometimes a home equity loan might be referred to as a home equity installment loan.
A home equity loan also comes with virtually all of the same closing costs (origination fees, appraisal fees, application fee, etc.) associated with taking out a traditional mortgage. The lender may waive some of these fees.
You may also be responsible for a prepayment penalty if you pay more than your required monthly payment. Sometimes people do this to get rid of their loan debt faster, but you could be penalized, so talk to your lender to make sure you know the terms.
Learn more about how a prepayment penalty works.
Which one is better?
Before settling on a HELOC or home equity loan, you should figure out how you plan to spend the money and pay it back. If you have a specific purchase in mind, like a very expensive roof replacement, a home equity loan might make more sense for this one-time purchase. You will get a fixed interest rate and a predictable payment schedule.
The greatest benefit and also drawback to home equity loans are their simplicity; the loan will be paid in an equal number of installments and there isn’t much else to it. However if you borrow more than you need, you’re still stuck paying interest on the entire loan. Borrowers might also risk under-borrowing and potentially need to take out another loan.
HELOCs on the other hand offer more flexibility but also more risk. You have the freedom to borrow as much or as little as you need (and you're only charged interest on that amount) — but the lender may set a withdrawal minimum, forcing you to spend a certain amount. Or you might abuse the line of credit and overspend more than you should.
With a HELOC, you have options when it comes to repaying the loan (what you pay during the draw period vs repayment period) — but the interest is variable and, if you’re not financially prepared in the first place, the payments may be higher than anticipated.
You may want to start repaying your home equity loan or HELOC early. Home equity loans are more likely to come with a prepayment penalty over a HELOC, but every lender is different so always ask.
Downsides of both
It is possible that neither a HELOC nor home equity loan is a good idea for you. HELOCs and home equity loans both have high costs in the form of interest and fees that may not make this type of loan worth it. You also run the risk of losing your house for both of these types of second mortgages.
It’s common to want to take out a HELOC or home equity loan to consolidate debts, especially high-interest credit card debt. However, if you’re not financially savvy or good at paying your bill, then you may simply wind up just transferring debt from one source to another and owing even more.
Alternatives to a HELOC or home equity loan
If you only wanted to make renovations to your home, a more straightforward home improvement loan may offer you enough funds to do so without the added costs that come with a home equity loan or line of credit. You might even get more savings and better rates with a green loan if you’re looking to make your home more environmentally sustainable.
A cash-out refinance might have lower rates than a HELOC and can help you save money by potentially lowering your mortgage payments.
Although it may sound banal, if you want to save money for a big expense you can always open a high-yield savings account. Making a deposit or two every month can help a lot.