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For many Americans, buying a home is one of the biggest investments they’ll ever make. But homes are highly illiquid assets.
In other words, once your money goes into your home, it’s difficult to get it back out again (without selling, anyway).
Home equity loans and home equity lines of credit, or HELOCs, provide a way to circumvent that reality.
Both let you pull from the cash invested in your home so you can access the money that’s rightfully yours.
However, terms and specifics vary between lenders, and HELOCs and home equity loans aren’t equal.
Thus, you should take stock of their nuances and shop around different lenders before applying for either one.
HELOC vs. Home Equity Loans Overview
Equity is the difference between what you owe on your house – such as a mortgage or personal loan secured by your home – and its market value.
So, if you own your home outright, you have 100%. But, if half of your house is under mortgage, you only have 50% equity.
Tapping into your home’s value with either a home equity loan or a HELOC is considered taking out a second mortgage on your home.
In other words, you’re putting your house up as collateral for your debt – and if you don’t pay up, the bank can repossess your home. But each loan approaches your equity a different way.
You can borrow up to 75-85% of your equity in a single lump sum loan with a home equity loan. Then, you repay the loan at a fixed interest rate over 5-30 years.
Taking out a home equity line of credit is more like securing a credit card with your house.
This revolving line of debt comes with a set maximum borrowing limit (usually 85% of your equity or less) that you can pull from any time you need throughout your draw period.
Then, during the repayment period, you pay back your loan – plus interest.
Home Equity Loans Pros and Cons
- You receive loan in one lump sum
- Loans carry a single, fixed interest rate
- Some lenders waive extra fees involved with taking out your loan
- You can deduct interest on your taxes if you use the funds to “substantially” improve your home
- You can only borrow once per loan
- You pay interest on the whole loan amount
- If you tap too much equity and the housing market crashes, you may owe more than your home’s value
- Must have at 15-20% equity to qualify
- If you default on your loan, you might lose your house
Understanding Home Equity Loans
Home equity loansare fixed interest rate installment loans that tap up to 85% of the equity in your property by using your house as collateral on your debt.
Once you apply and receive approval, you’ll get your loan as one lump sum. Then, you repay the loan over a set period of time defined by your loan agreement.
Unlike some types of loans, you can use a home equity loan to pay for almost anything. Some common uses include home renovations and paying down higher-interest debts, though you can also finance your wedding or even take a vacation.
However, if you want to write off the interest on your taxes, you must use the funds to “buy, build, or substantially improve” the home securing the loan.
Loan Terms and Rates
Interest rates on a home equity loan vary on the market rate, as well as your:
- Credit score
- Payment history
- Loan amount
Typically, you can expect to pay anywhere from around 3% to over 8% on a home equity loan.
And, depending on the amount you borrow, you may repay your loan over the course of 5 to 30 years.
While that seems like a long time, bear in mind that your loan payments won’t change over time due to the fixed interest rate – just like a regular mortgage.
Advantages and Disadvantages of Home Equity Loans
Home equity loans let you tap the cash sitting idly in your property, which can then fund various useful projects.
For instance, you can renovate your home, improve its value, pay for your college tuition, or pay down other debts.
And, if you have good credit, you can often do this at a lower interest rate than most personal loans and credit cards.
But home equity loans also carry a risk of tanking your credit score or even foreclosure if you fall behind on payments.
And if the value of your home collapses while your loan is active, you may find yourself in debt for more than your home is worth, which puts you underwater if you’re looking to sell out.
HELOC Pros and Cons
- Only borrow (and pay interest on) what you need
- You can reborrow from the same line of credit without reapplying
- Easy-access emergency reserve for unexpected bills or revolving expenses
- Like a home equity loan, you can deduct interest on your taxes if you use the funds to substantially improve your home
- Interest rates and loan payments may fluctuate
- Often only available from banks and credit unions
- Open-ended loans can make determining your payments or total repayment term difficult
- Easy access to such large credit lines tempts some borrowers to overspend
- You risk losing your home if you fall behind on payments
Understanding Home Equity Lines of Credit (HELOCs)
Compared to a home equity loan, a home equity line of credit acts more like a credit card that uses your house as collateral.
With a HELOC, you apply and receive approval for a set limit of up to 85% of the equity in your home. Then, you can borrow and repay the money as often as you need as long as you make monthly interest payments.
With a HELOC, you only pay interest on what you use, unlike a home equity loan. And because you have access to a revolving line of credit, you don’t have to reapply every time you need cash.
That’s good news for borrowers who need repeated access to capital or aren’t sure how much they’ll need.
Loan Terms and Rates
HELOCs carry variable APRs, which means that the rate fluctuates with market pressures. Some lenders offer intro APRs as low as 1.7%, while you might see interest rates of 25% or higher at the upper end. But typically, you can expect to pay 3-8% APR on a HELOC (at least to start).
That said, after you’ve borrowed from your credit line, some lenders let you set aside a chunk of your loan at a fixed interest rate.
Others may let you refinance from a HELOC into a home equity loan once your draw period ends, which can lower your long-term interest.
And speaking of a HELOC’s draw period, or the term during which you can pull from your credit line usually lasts around 10 years.
Throughout this time, you’re only responsible for paying the interest on your withdrawals. But once the draw period ends, you move into the repayment period, which extends for another 10-20 years as you pay down your loan balance (with interest, of course).
Bear in mind that paying principal plus interest costs far more than interest alone, depending on how much you borrow.
As such, you should budget for the day when your draw period ends early on to avoid the sudden sticker shock.
Advantages and Disadvantages of Home Equity Lines of Credit
Taking out a home equity line of credit lets you pull from revolving debt when you need it, which means you only pay interest on the amount you use.
This provides the flexibility for homeowners to pay for ongoing renovations, college tuition, unexpected medical or emergency expenses, and other debts as they arise.
However, if interest rates rise, your payments will soar right along with them, which can make determining the cost of your loan a hassle. (Not to mention, you may find yourself paying much more than you originally bargained for.)
What is the Difference Between a Home Equity Loan and a Home Equity Line of Credit?
A home equity loan is a fixed-rate loan paid out in one lump sum and repaid in regular installments. They may come with higher APRs to start, but their rate won’t rise over the life of the loan.
By contrast, a HELOC is a revolving line of credit that you can borrow from and repay as needed during the draw period.
Then, you repay the loan plus interest once you enter the repayment period. HELOCs may start at lower introductory APRs, but their interest rates will fluctuate with the market over time.
When Should You Use a Home Equity Loan?
Home equity loans are generally better if you need a set sum of money right now. These funds work well for paying off higher-interest debt or the cost of a renovation.
Additionally, they can provide peace of mind for borrowers who want the certainty of a fixed interest rate.
However, if you underestimate your financial needs, such as on a renovation that extends beyond your planned budget, you’ll have to reapply for additional funding.
When Should You Use a Home Equity Line of Credit?
HELOCs make better loans if you’re not sure how much you’ll need to borrow or when and if you’re comfortable with a variable interest rate.
For instance, some borrowers use HELOCs to smooth out the ups and downs in their freelance or self-employment income, to cover ongoing educational or renovation costs, or as a backup for emergencies.
You may also prefer a HELOC if you predict you’ll make more money in the future, such as if you’re in the startup phase of building your own business.
HELOC vs. Home Equity Loans: Which is Better?
The better loan depends on your needs, desires, and risk tolerance.
Home equity loans may serve you well if you need a lump sum now and predictability in your payments later.
Additionally, if you have a history of taking on more debt than you can handle, you may prefer a home equity loan to an open line of credit.
But if you need the flexibility to borrow and repay your loan on your terms, and you’re comfortable with the risk of a variable APR, a home equity line of credit may work in your favor.
That said, both loans come with the risk of losing your house if you can’t repay your debt – so choose wisely.
Bottom Line: HELOC vs. Home Equity Loans
Both home equity loans and HELOCs let homeowners tap their investment to pay for emergencies, renovations, educational costs, or other expenses.
But the better loan for you depends on your needs, such as whether you’ll need recurring or one-time funds and when you’ll be able to repay your loan.
Before taking out either loan, you should shop different lenders and account for various fees and interest rates.
And above all, you should decide whether taking out a loan is necessary – and understand what it means for your future if you sell your house or the market bottoms out.