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

One of the primary benefits of homeownership is building equity. The value tied up in your home increases as you pay down your mortgage, and home values rise. You can find out your current equity by subtracting how much you owe from the current market value of your home. The difference is your equity. It is like having a personal saving account for your home, except that the value is looked up and can’t be accessed until you sell or borrow against the equity. Banks will allow you to borrow like this through either a home equity loan or a home equity line of credit (HELOC).

It can be handy if you need emergency maintenance funds or want to make home improvements. But by doing this, you’ll be taking on some financial risks.

Borrowing on your equity

What differentiates these two types of loans from personal loans is that the house is the collateral. If you can’t keep up with payments, you risk going into foreclosure. Also, these two types of “second mortgages” will draw on your equity and thus reduce the value of your home. There’s a real chance you could borrow more than the home is worth. It is a severe problem if you need to move and must sell. You’ll either lose money on the sale or be unable to move at all. Most lenders for both loans will cap the amount you can borrow at 85% of your current equity. Other factors are also considered, such as credit score, income, and market value in how much you can borrow.

Both loans have pros and cons, so it is essential to choose wisely. Most financial planners will stress that the only justification for tapping into your equity is to add value to your home. Consider that as you look at the pros and cons of both options.

Home equity loans

A home equity loan is one in which the borrower gets a one-time lump sum. This loan is to be repaid over a fixed term at a fixed interest rate, which means that your monthly payments will be the same month after month, year after year. It makes it easy to account for in your budget. However, you’ll be paying the home equity loan and your current mortgage payment.

Pros

• Great as a source of funds for major projects or one-time expenses
• It comes at a fixed interest rate over a set period

Cons

• Taking one large chunk out of your equity can work against you if property values decline in your area.

Home equity lines of credit (HELOC)

With a HELOC, you’re given a line of credit that you can draw on over a set period. It makes it much like a credit card. The beauty of this is that you’ll only be paying interest on what you borrow. HELOCs usually start with a lower interest rate than a home equity loan. But they come with an adjustable interest rate, which will rise or fall depending on the movements of a benchmark. Your monthly payments will change depending on the interest rate and how much you have borrowed. Some lenders will allow you to carve out a portion of your HELOC loan and set it at a fixed rate. You’ll still be able to draw on the remaining balance at the adjustable rate. Some banks also offer it in two different forms:

• One with an interest-only draw period
• One with a draw period where you pay back interest and principal

With the latter option, you can pay back the loan sooner. When the credit line expires, the principal’s repayments will begin. Once the outstanding balance and interest are paid back, the lender may or may not renew your line of credit.

Pros

• You pay interest only on the amount you’ve borrowed
• It may come with the option of paying only the interest during the draw period

Cons

• An adjustable interest rate makes your monthly payments unpredictable
• If you’re not careful, you can overspend and land yourself with large principal and interest repayments once the repayment period begins.

So which is better?

As with so much else in real estate, the answer is that it depends. One will be better than the other, depending on your situation. Think about how much money you’ll need and for what purpose. Consider monthly payments, interest rates, and tax advantages. A home equity loan is better if you need a large amount to cover expenses now and don’t plan on borrowing again. But a HELOC is the right choice if you need cash over a staged period, like for a modeling project that will take three years to complete.

The equity in your home can provide ready cash for when you need it. But it will mean taking a risk with a second mortgage that can lead to foreclosure in a worst-case scenario. Different banks will also have other policies on these loans, so ask your lender the right questions to know what you agree to. Before deciding, talk carefully with your financial advisor about the best course of action.