You have a considerable sum of home equity and want to convert it into cash. In this case, you’ve likely considered a home equity loan and a home equity line of credit (HELOC) to make it happen. But how do you know which option is best for your financial situation? Here’s a closer look at the specifics of each, along with their pros and cons, key similarities and differences, and what to consider to make the right choice.
Overview of Home Equity Loan vs Line of Credit
Both debt products let you leverage your home equity to meet financial goals, make costly home repairs or big-ticket purchases, consolidate debt or use however else you see fit.
Importance of Understanding the Differences
While home equity loans and HELOCs share a few similarities, there are also differences to be aware of to make an informed decision. More on these shortly.
What is a Home Equity Loan and How Does It Work?
A home equity loan is a type of installment loan that acts as a second mortgage and uses your home as collateral. Funds are disbursed in a lump sum and payable in equal monthly installments over a set period.
You can borrow up to 85% of your home equity with most lenders. So, if you owe $215,000 and your property is valued at $425,000, you may qualify for a home equity loan of up to $146,250 ($425,000 * .85 – $215,000).
Pros and Cons of Home Equity Loans
Pros
- Fixed interest rate means predictable payments and borrowing costs
- Potential tax benefits if the loan proceeds are used to make substantial home improvements
Cons
- Must pay interest on the entire loan amount
- Risk of foreclosure if you default on the loan payments
What is a Home Equity Line of Credit (HELOC) and How Does It Work?
A HELOC is a revolving line of credit that operates like a credit card. You get a pool of funds to draw from as needed up to the preset credit limit. The latter is based on the amount of equity you have in your home – typically capped at 85% – and other financial factors.
Withdrawals are permitted during what’s referred to as the draw period, typically spanning 5 to 10 years. You’ll also make interest-only payments with most lenders during this window. Keep in mind that rates are usually variable on HELOCs and fluctuate with market conditions.
You can borrow, repay and borrow again up to the credit limit until the draw period ends. But once it closes, you enter the repayment period and begin making principal and interest payments. This period typically spans 10 to 20 years.
Pros and Cons of Home Equity Line of Credit (HELOC)
Pros
- Only pay interest on the amount you borrow
- Ability to withdraw funds as needed
Cons
- Variable interest rates mean unpredictable borrowing costs
- Monthly payments could increase significantly when the draw period ends
Comparative Analysis: Home Equity Loan vs Line of Credit
Similarities
- Collateral Requirements: Both home equity loans and HELOCs use your home as security.
- Application Process: The application process is also similar, and the lender will generally require a home appraisal.
- Closing Costs: Both home equity products involve closing costs, although you may be able to roll them into the principal balance.
Key Differences
- Structure and Terms: Home equity loans are a type of installment debt, but a HELOC is a revolving line of credit.
- Interest Rates: Home equity loans generally come with a fixed interest rate, while variable rates are standard with HELOCs.
- Repayment Terms: Home equity loans are payable in equal monthly installments. However, HELOCs typically require interest-only payments during the draw period. And when it ends, you’ll be responsible for a higher monthly payment that includes both principal and interest.
Situations Best Suited for Home Equity Loans
Are you still torn between the two options? Here are some instances where a home equity loan would make the most sense.
When Fixed Rates are Beneficial
If market conditions are favorable, interest rates will likely be on the lower end. In this case, you can expect to get a good deal on a home equity loan, assuming you have a solid credit score and strong financial profile. And doing so helps you take advantage of lower borrowing costs.
Large, One-Time Expenses
Home equity loans are also best for larger-scale planned expenditures. Since you get a lump sum of cash upfront, you can have the funds handy to cover the expense right away and start repaying what you owe in affordable monthly installments shortly after.
Situations Best Suited for HELOCs
Below are situations where a HELOC could be ideal.
Flexibility in Borrowing and Repayment
If you have expenditures in mind but aren’t quite sure about the specifics, or if you want a cushion for a rainy day, consider a HELOC. It gives you the option to borrow as needed, control the interest you pay and enjoy smaller interest-only payments during the draw period.
Ongoing Financial Needs
You never know when life will happen. And if reserves are limited, a lone financial emergency is enough to blow up your budget and set you back. But having a HELOC at your disposal can provide peace of mind, knowing you have a pool of funds to meet your financial needs.
How to Decide Which is Right for You
When deciding if a home equity loan or HELOC is right for you, keep your financial situation and money goals in mind.
Evaluating Your Financial Situation
Begin by assessing where you stand financially. How much money do you have saved? Do you have wiggle room in your budget to afford an additional debt payment? What unmet financial needs do you currently have? Do you have a credit score, income source and DTI that lenders will find acceptable? Consider all these factors when deciding between the two types of home equity products.
Understanding Your Financial Goals
How do you plan to use the funds from a home equity loan or HELOC? If it’s for a considerable one-time expense or to consolidate high-interest debt, a home equity loan may be best. But if you want more flexibility and the ability to access funds over an extended period, a HELOC is ideal.
Impact on Home Ownership
With a home equity loan, you borrow against your home’s equity with fixed repayment terms, which could lead to foreclosure if you fail to meet payment terms.
A HELOC lets you draw funds as needed but also increases your risk if you can’t manage variable interest rates, which can rise over time.
Home Equity Loan vs Line of Credit: Which is Better?
A home equity loan gives you a lump-sum amount. This is ideal if you need a specific amount for a one-time project. The loan comes with a fixed interest rate, which means your payments remain consistent and easier to manage over time.
On the other hand, a HELOC works more like a credit card. Remember, you can withdraw money from the HELOC as needed during a draw period, typically between five and 10 years. The ability to pull funds whenever you’d like can give you peace of mind if you have ongoing expenses or if a financial emergency arises.
When deciding between these options, consider your current and future financial needs. Also, review offers from different lenders to find the best fit for your situation.
