Many homeowners don’t realize they’re sitting on an untapped source of money that they can use to finance other projects or consolidate other expenses. Actually, they’re sitting in the source: the portion of their home that they’ve paid for, which is referred to as equity. When you take out a standard mortgage, you borrow money from a lender with the home itself as collateral—you and the lender understand that if you fail to make payments, they can take and sell the home to recoup their losses. Once you’ve paid off a portion of your mortgage, you can then borrow against the value of your home (minus the money you still owe on your mortgage) using one of two different products: a home equity loan or a home equity line of credit (HELOC). These two products sound the same, but they differ in several significant ways. It’s a good idea to understand the ins and outs of the battle of home equity loan vs line of credit, because the differences can help you save—or lose—significant assets.
1. Both home equity loans and home equity lines of credit are loans that allow a homeowner to borrow money based on the value of their home, minus the amount of mortgage left to pay.
You’ve worked diligently to pay down your mortgage, so you’ll be glad to know that you may be able to use the equity you’ve built to finance other projects. Home equity loans and home equity lines of credit (HELOC) allow homeowners with good credit to borrow against the owned value of their homes; in other words, you can borrow from a lender using the portion of your home you’ve already paid for and own outright—the difference between the value of your home and the amount you still owe on your mortgage. It’s key to note that this calculation uses the current market value of your home, not the purchase price, because the lender will be using your house as the collateral for the loan in the event that you default, so you can borrow using the difference between the current resale value and your current mortgage balance as your starting point. Most lenders will only allow you to leverage your house to a maximum of 85 percent in total loans, so you won’t be able to borrow the entire amount of your equity; the bank wants to leave a cushion in case you default and minimize your likelihood of overextending your credit so you don’t default in the first place. The first step when considering a home equity loan or line of credit is to make this calculation and determine how much you can potentially borrow. To do this, you’ll need to find out the balance left on your mortgage and get an appraisal to find the real value of your home.
2. A home equity loan is disbursed as a lump sum, whereas a HELOC is disbursed as needed.
While their names sound similar and they borrow from the same pool of money, a home equity loan and a HELOC are not the same thing. A home equity loan is very similar to a mortgage, and in fact borrowers will go through the same process to take a home equity loan as they did for their initial mortgage. Once the loan is approved and closed, it will be disbursed to the borrower in one lump sum payment, to be put in the bank and spent as needed. Repayment begins immediately on the total sum of the loan. These loans are ideal when borrowers need to make one or two large payments to consolidate other expenses or to pay for a large home improvement project and want the stability of knowing exactly what their payment will be each month.
With a HELOC, once the loan is approved and closed, it sits in the lender’s bank until the borrower chooses to draw on it. No repayment is required until money is withdrawn, because it is essentially available credit and the money hasn’t been borrowed yet. Depending on the lender and the state, there may be some maintenance fees required as time passes without activity, and in addition, borrowers may incur transaction fees when they withdraw funds. Repayment only begins after money is withdrawn and then is based on the money withdrawn, not on the total amount of the line of credit. Depending on the fee structure, a HELOC can be a good way to cover expenses that require payments over the course of a longer period of time; by repaying only on the amount you’ve actually taken, your payments will be smaller and you can more efficiently pay off each portion you withdraw rather than having to make a larger payment on the full amount of the loan as with a home equity loan.
3. Home equity loans have fixed interest rates. HELOCs have variable interest rates.
Like other home loans, borrowers will repay home equity loans and HELOC with interest. A significant difference between HELOC interest and home equity loan interest is the nature of the rates: a home equity loan has fixed-rate interest, and a HELOC has variable interest rates.
What does this mean for the borrower? Home equity loans work very much like a second mortgage (in some cases, they’re actually called second mortgages). The loan closes with an interest rate based on the market and the borrower’s credit, and then the borrower makes a set number of payments over a set period of time for a set amount. This approach makes it easy to budget for the payments and provides stability for the borrower and the bank. With a HELOC, the rate is variable, which means that the initial interest rate will be set based on the market and the borrower’s credit, but will then shift periodically based on the prime market rate—a jump of as much as 2.5 percent annual percentage rate on a Bank of America HELOC, for example, after the introductory period. There are potential benefits and drawbacks to this repayment plan. If you know you’re going to repay the amount withdrawn quickly and rates are low, it’s a great way to save money on interest. If, however, the withdrawn funds will be paid back over a longer period of time, variable rates can be fickle: They can jump suddenly, making it difficult or impossible to make payments that haven’t been budgeted for. With either form of equity loan, the collateral is your home. Unless you’re confident that you’ll be able to make the payments should the rates rise, a fixed-rate home equity loan is the safer choice. If you have the financial wherewithal to cover higher payments, the variable rate can save you some money. In either case, you’ll want to budget carefully and avoid borrowing more than you need—once you’ve leveraged such a large percentage of your home, a financial disaster means you could lose your greatest asset.
4. The repayment term for a home equity loan starts as soon as the loan is disbursed, whereas a HELOC has interest-only payments for a certain period.
Home equity loans are amortized, just like traditional mortgages are, so each month’s payment is a combination of principal and interest. At the beginning of the loan repayment period, which begins immediately after the loan is disbursed, most of the payment goes toward interest and very little goes toward the principal loan amount. Over the course of repayment, that balance shifts, so by the end of the repayment period the majority of each payment will go toward the principal. This style of repayment allows interest-first repayment while keeping the payments consistent.
Home equity lines of credit are broken into two parts: the draw period and the repayment period. During the draw period, which may be as long as 10 years, you can take money out of the HELOC and begin making payments on the withdrawn amount immediately—but usually those payments are interest-only, which means they’re quite small. At the end of the draw period, after which the borrower can no longer take out more money, the payments will change to principal and interest for the length of the repayment period, which can be as long as 20 years.
5.Monthly payments on a home equity loan stay the same, whereas HELOC monthly payments can change.
You’ll pay back a home equity loan over the course of 5 to 30 years, depending on how much you borrow, how much you plan to pay each month, and your lender’s preference. Each monthly payment will be the same amount for the life of the repayment plan, with an amortized combination of principal and interest in each payment. Some home equity loan lenders will allow you to make additional payments on the principal through the years to repay the loan sooner, which can save money in interest.
Another difference between home equity loan and line of credit is that HELOC monthly payments will most likely change. Because the payments are dependent on how much money you’ve withdrawn, it can be difficult to predict when payments will begin and how much you’ll owe each month going forward. In addition, the change from interest-only payments to principal-plus-interest at the end of the draw period can cause the payment amount to rise sharply, so it’s important to have an idea of how high that payment will go before the first one comes due and budget accordingly.
6. Depending on a homeowner’s circumstances, one may be a better option than the other.
Home equity loan vs HELOC: Which one is best for you? The answer to this question depends on your reason for taking the loan, your overall financial health, and your tolerance for risk in exchange for saving some money. If the project you’re hoping to finance has one or two large payments and you’d prefer simple, stable payments over a set period of time, a home equity loan will have you covered. If, on the other hand, you’re planning to finance a long series of expenses or pay for a college education with your loan, or you’re anticipating expenses and want to have a pool of “emergency” money available as a backup, a HELOC can offer you more flexibility and better interest rates. You’ll want to talk with your lender about the interest rates and terms, and ask if there’s a penalty for early payments on the principal so that you can compare the two types of loans and decide which best fits your needs.