HELOC vs. Home Equity Loan: Comparing Equity Options
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Richard Haddad Executive EditorClose
Richard Haddad Executive EditorRichard Haddad is the executive editor of HomeLight.com. He works with an experienced content team that oversees the company’s blog featuring in-depth articles about the home buying and selling process, homeownership news, home care and design tips, and related real estate trends. Previously, he served as an editor and content producer for World Company, Gannett, and Western News & Info, where he also served as news director and director of internet operations.
With home values surging nearly 50% in the last four years, many homeowners are sitting on a significant equity windfall. If you’re considering tapping into this equity, a HELOC or a home equity loan could be the way to go.
These options offer the flexibility to finance home improvements, consolidate debt, or even cover major expenses. But when it comes to a HELOC vs. home equity loan, how do you decide which is right for you?
In this post, we provide at-a-glance information to help you understand the differences and similarities between a HELOC and a home equity loan so you can make an informed choice that fits your life and financial goals.
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HELOC vs. home equity loan: Differences
A HELOC and a home equity loan are both ways to tap into your home’s equity, but they function quite differently. A HELOC is more like a credit card with a variable interest rate, allowing you to borrow what you need when you need it. In contrast, a home equity loan provides a lump sum with a fixed interest rate, giving you predictability in your payments. Let’s break down these two options further to help you understand which might suit your needs better.
Home equity line of credit (HELOC)
- Credit limit with a borrowing period: You’re given a set credit limit and can borrow funds as needed, typically within a 10-year draw period.
- Flexible access to funds: You can withdraw money up to your limit, only paying interest on what you actually use.
- Variable interest rates: Most HELOCs have rates that can fluctuate based on market conditions, affecting your payment amounts.
- Interest-only payments during the draw period: Typically, you’re only required to make interest payments during the borrowing phase, with principal payments starting later.
- Repayment phase after borrowing ends: Once the draw period closes, you’ll enter a repayment phase where you pay back the remaining balance, often over 10 to 20 years. Payments will change based on the amount you draw and the current interest rate.
Home equity loan
- Fixed loan amount: You apply for a specific amount based on your needs and receive it in a lump sum.
- Fixed interest rate: The interest rate is locked in from the start, so your payments remain consistent throughout the life of the loan.
- Predictable monthly payments: Each payment is the same every month, covering both interest and a portion of the principal.
- Ideal for one-time expenses: Best suited for large, one-off expenses where you need a set amount of money upfront.
- Repayment over a fixed term: You’ll repay the loan over a predetermined period, typically 5 to 30 years, depending on the loan terms.
HELOC vs. home equity loan: Similarities
- Both are secured loans backed by collateral
- Borrowed funds can be used as you desire
- Both incur closing costs
- Loan amount limits (lenders typically allow you to borrow up to 85% of your home’s value minus the current balance of any existing mortgages)
- Possible tax benefits if used for home improvements
- Impact on your credit score when you open or use these loans
- Cost between 2% and 5%* of the total loan or line of credit amount
*While the costs may be similar, your closing costs will depend on your credit history, the lender, interest rates, and the property.
Calculating your home equity: The formula for determining your home equity is “Current market value minus the outstanding mortgage balance.” For a more detailed guide, check out our article on how to calculate home equity.
HELOC vs. home equity loan: Loan requirements
Both HELOCs and home equity loans require you to meet certain criteria to qualify, as they are secured loans backed by the equity in your home. While specific requirements can vary by lender, there are some general qualifications you’ll need to meet for either option:
- Sufficient home equity: Most lenders require that you have at least 15% to 20% equity in your home. This means your loan-to-value (LTV) ratio should be no higher than 80% to 85% after the new loan.
- Good credit score: A credit score of at least 620 is typically needed for a HELOC or home equity loan, though a higher score can help you secure better terms and interest rates.
- Stable income and employment: Lenders will verify your income and employment history to ensure you can afford the loan payments. They’ll look for a steady job history and sufficient income to cover your current debts and the new loan.
- Debt-to-income ratio (DTI): Most lenders prefer a DTI ratio of 43% or lower. This means your monthly debt payments, including your potential new loan, should not exceed 43% of your gross monthly income.
- Property appraisal: An appraisal is usually required to determine the current value of your home and the amount of equity you have. This helps the lender assess how much you can borrow. However, there are some circumstances where a lender may not require an appraisal.
Meeting these requirements doesn’t guarantee approval, but it does give you a better chance of qualifying for a HELOC or a home equity loan. Additionally, stronger financials, like a higher credit score or lower DTI, may help you secure more favorable loan terms.
HELOC vs. home equity loan: Pros and cons
Pros of a HELOC
- Flexibility to handle ongoing or unexpected expenses
- No payments unless you use the funds
- Interest-only payments during the draw period
- Once you pay down the balance, you can borrow again
- Can draw account funds for up to 10 years
- Lower startup interest rate followed by a variable rate
- More affordable than some borrowing options
- Easier qualifications than some other loans
Cons of a HELOC
- Credit lines expire and then must be renewed or repaid
- Variable rates can increase your monthly payments and debt over time
- Easy access can lead to unnecessary purchases or overspending
- Without principal payments, credit lines can take longer to pay off
- If you fail to repay the loan, you can lose your home
Pros of a home equity loan
- Lump sum of money for renovations or debt consolidation
- Fixed interest rate throughout the life of the loan
- Monthly payments remain consistent
- Set repayment schedule for better planning
- Longer repayment periods compared to HELOCS (up to 30 years)
- Loan agreement does not need to be renewed or extended
- Lower credit score requirement compared to a HELOC
- Lower closing costs than a traditional refinance
Cons of a home equity loan
- Less flexible loan disbursement and payment terms
- Monthly payments are typically higher than a HELOC’s initial payments
- Must pay fees and begin payments with interest right away
- Unable to reborrow on the loan while paying down the balance
- Loan is not renewable or extendable (must be refinanced anew)
- Can be higher closing costs than using a HELOC
- If you fail to repay the loan, you can lose your home
HELOC vs. home equity: Loan examples
To better understand how a HELOC and a home equity loan work, let’s look at a simple example using the same house and the same amount of equity.
Imagine you have a home valued at $400,000, and you still owe $250,000 on your mortgage. This means you have $150,000 in home equity. Lenders typically allow you to borrow up to 85% of your home’s value minus the remaining mortgage balance. In this case, 85% of $400,000 is $340,000. Subtract the $250,000 you owe, and you’re left with $90,000 as the maximum amount you can borrow.
$85,000 HELOC drawing $20,000
You decide to open a HELOC with a credit limit of $85,000, giving you access to this amount over a 10-year draw period. You initially draw $20,000 to cover a kitchen remodel.
- Draw period: During the first 10 years, you can borrow from the HELOC as needed. You only pay interest on the $20,000 you withdrew, not the full $85,000. With a variable interest rate, your payments may vary, but they are lower initially since you’re primarily paying interest.
- Repayment period: After the 10-year draw period, you enter a 10- to 20-year repayment phase. If you still owe $20,000 plus any interest, you’ll now make monthly payments that include both principal and interest until the balance is paid off.
$85,000 home equity loan
Instead of a HELOC, you opt for an $85,000 home equity loan to finance multiple home projects, including the kitchen remodel, a bathroom update, and a new roof.
- Lump sum disbursement: You receive the entire $85,000 upfront in a single payment, which you use to fund the home improvements.
- Fixed interest rate: The loan comes with a fixed interest rate, so your monthly payments are consistent and predictable over the term of the loan, which could be 15 years, for example.
- Repayment schedule: Each month, you make equal payments that cover both interest and a portion of the principal, giving you a clear path to pay off the loan within the 15-year term.
Both options provide ways to tap into your home’s equity, but they serve different purposes depending on whether you need flexible access to funds over time (HELOC) or a lump sum for immediate expenses (home equity loan).
Using equity to buy before you sell
If you’re considering using your home equity to purchase your next home, HomeLight’s Buy Before You Sell program can streamline and simplify the entire process. This modern solution allows you to unlock your equity to make a strong offer on your new home while avoiding the stress of timing the sale of your current home.
HomeLight’s innovative program also gives you the financial flexibility to move only once and at your own pace, making the transition to your new home smoother and more convenient. Here’s a quick look at how HomeLight Buy Before You Sell works:
HELOC vs. home equity loan: Which is right for you?
Deciding between a HELOC and a home equity loan depends on your financial situation and how you plan to use the funds.
HELOC: If you need flexible access to funds over time for ongoing expenses or projects, a HELOC offers that adaptability. It allows you to draw money as needed, with the advantage of potentially lower initial payments during the draw period. However, keep in mind that the variable interest rates can make budgeting a bit challenging.
Home equity loan: On the other hand, if you need a lump sum for a large, one-time expense and prefer the certainty of fixed monthly payments, a home equity loan might be the better option. Its fixed interest rate and predictable payment schedule make it easier to plan your finances and know exactly when the loan will be paid off.
Evaluate your needs, the amount of equity you have, and your comfort with variable versus fixed interest rates and payments. Speaking with a financial advisor can also help you weigh your options and choose the loan type that best fits with your long-term goals.
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