HELOC Vs. Home Equity Loan: Pros, Cons And Alternatives

Home equity is one of the major benefits to being a homeowner. Through a combination of increasing home market value and faithfully paying their mortgage on time, homeowners can strengthen their personal finances by building significant equity.

Products such as a home equity line of credit (HELOC) or a home equity loan – which are both considered a type of second mortgage – can help homeowners tap into their growing financial power.

A HELOC works like a credit card that allows borrowers to use an open line of credit, as needed. A home equity loan, on the other hand, provides a specific upfront lump sum that borrowers can use at their discretion. You’ll pay against that full amount, with interest.

But which option is best, and under what conditions? Let’s explore what homeowners should know about a HELOC versus a home equity loan.

Key Differences Between HELOCs And Home Equity Loans

What Is A HELOC And How Does It Work?

A HELOC is a revolving line of credit. With a HELOC, homeowners can tap a maximum amount of credit using the equity in their home. You’ll only have to pay back what you use, and you’ll also have a “credit limit” that replenishes when you make a payment. Typically, HELOCs also have lower interest rates than credit cards.

A HELOC has two parts: the draw period and repayment period. During the draw phase, the line of credit is open and ready to use. Draw periods typically last 5 – 10 years. Once the repayment period kicks in, borrowers make monthly payments against what they’ve borrowed, plus pay interest. Typically, a repayment period lasts 10 – 20 years.

What Is A Home Equity Loan And How Does It Work?

A home equity loan lets a homeowner use their home’s equity as collateral to secure a loan. The lender provides the borrower with an upfront lump sum, which they’re free to use according to their wishes. Homeowners then repay the loan with interest.

Typically, a homeowner can borrow up to 80% of their home’s value, minus what they owe on their mortgage. Limits may be different depending on your lender.

Home equity loans typically have a fixed interest rate, which often means you’ll have the same monthly payments throughout the loan term.

HELOC At A Glance

• Is a secured loan backed by collateral
• Functions like a credit card
• Features a maximum amount
• Requires closing costs
• Usually has a variable interest rate
• Considered a good option for home improvements
• Has lower interest than a credit card
• Requires that you pay only for the amount you use

Home Equity Loan At A Glance

• Uses your home as collateral, making the loan secured
• Provides a lump sum for the borrower to use at their discretion
• Might require a balloon payment (lump sum) at the end of the term
• Might have prepayment penalties
• Usually requires closing costs
• Has a fixed interest rate, in most situations
• Often used for education costs, emergency financial needs or debt consolidation

HELOC And Home Equity Loan Pros And Cons

Let’s compare some pros and cons of HELOCs and home equity loans.

HELOC Vs. Home Equity Loan Pros

Home Equity Loan Vs. HELOC Cons

When To Consider A HELOC

If you need regular access to cash, a HELOC might be a good option. Real estate investors can use HELOCs to renovate homes to resell, and HELOCs are also a solid option for homeowners looking to turn a fixer-upper into their dream home.

When To Consider A Home Equity Loan

If you’re thinking about debt consolidation, trying to pay for an emergency or looking for a way to pay for a college education, a home equity loan might make the most sense. You’ll have a consistent monthly payment to build your budget around, likely making it easier to handle recurring expenses.

How To Get A HELOC Or Home Equity Loan

The process for getting either of these second mortgages is similar. You’ll need to research lenders that offer these products and submit an application.

Typically, lenders will review some key financial information, including:

• Your credit score: A credit score of 620 or higher should allow a homeowner to qualify, and you’ll probably get a better interest rate the higher your score.
• Your debt-to-income ratio: Your DTI is your monthly debt payments divided by your gross monthly income, which gives lenders an idea of how you’re using the money you make.
• Your home equity: This will help lenders determine how much equity you have to borrow against.

Alternatives To Second Mortgages

If putting your home up as collateral isn’t the right solution for you, you can fund a large expense or a home renovation in other ways. Here are a few to consider.

Personal Loans

A personal loan allows borrowers to take out money for nearly any need. The loan term will usually vary from 12 – 60 months. Borrowers can typically find personal loans with a fixed interest rate or a variable interest rate.

Cash-Out Refinancing

It’s also possible to access and use home equity through a cash-out refinance, which allows a homeowner to turn equity into money by refinancing their mortgage with a bigger mortgage. They can use the difference between how much their house is worth and how much they owe on it to fund major purchases or projects. A cash-out refinance will replace your existing mortgage, it is not a second mortgage like a HELOC or home equity loan.

FAQs About A Home Equity Loan Vs. A Line Of Credit

Here are a few questions that people often ask when comparing HELOCs and home equity loans.

What is the difference between a HELOC and a home equity loan?

A borrower will get a home equity loan for a specific amount, usually with a fixed interest rate, and pay against that amount. HELOCs function more like a credit card, with a line of credit to be used as needed during the draw period. Most often, a HELOC will come with a variable interest rate.

What is the downside to a HELOC?

A HELOC could come with a few downsides. First, it’s likely to have a variable interest rate, which can make it difficult to plan a budget. Also, it can allow borrowers to rack up debt because every payment replenishes the overall line of credit. Finally, it requires a borrower to use their home as collateral, which brings a risk of foreclosure if the borrower doesn’t pay on time.

How is a $50,000 home equity loan different from a $50,000 home equity line of credit?

With a home equity loan, the borrower receives a lump sum and must eventually repay the entire amount with interest. They’ll typically pay in fixed installments. With a HELOC, the borrower can use as much or as little of the credit limit as they wish during the draw period. That means your payments will vary with how much of the line of credit you utilize.

The Bottom Line

Tapping into the equity in your home can be a great way to pay for major expenses, which can range from home improvements to the costs associated with attending college. Like with any loan product, you’ll need to pay on time or your financial situation could deteriorate quickly.

If you need help tracking your debts, download the Rocket Money℠ app. It provides a birds-eye view of your finances to help with getting every bill paid on time.