Should I Get a Home Equity Loan or Home Equity Line of Credit (HELOC)?
Your home is likely one of the most valuable assets that you own. If you’ve paid your mortgage payments on time to build equity or own the home outright, you should know that you can access funds that use your home’s equity as a loan. These types of loans are called a home equity loan or a home equity line of credit (shortened to HELOC).
In this article, we will take an overview of home equity loans and HELOCs, weigh the pros and cons of each, and compare what is the best option for homeowners.
What is a Home Equity Loan?
Granted to a homeowner based on the current equity in their home, a home equity loan is a fixed-term loan. Also known as an equity loan, second mortgage, and/or home equity installment loan, home equity loans enable borrowers to apply to a lender for a lump-sum payment that is repaid through a series of monthly fixed payments (including interest) for the term of the loan.
Loan Terms and Collateral of a Home Equity Loan
The equity in a borrower’s home is used to guarantee the loan as a form of collateral. One of the main requirements of a home equity loan is the amount of equity in the home - which need a substantial amount to be paid off before qualifying for a particular amount.
The lump-sum amount of the home equity loan is generally based on a number of factors, such as the combined loan-to-value ratio (more commonly known as the CLTV ratio). Usually, the home equity loan amount can be as high as 90% of the home’s appraised value.
Additional factors that influence how the lender decides to approve a equity loans include:
- Borrower’s credit history (including on-time payments for the original mortgage)
- Credit score
- The stated purpose of the loan (such as home renovations, college tuition, etc.)
- Outside economic factors (many lenders are suspending home equity loans in 2021)
One of the key factors of a home equity loan is that the interest rate is fixed. This means that it won’t fluctuate year by year over the term of the loan (which can range from 5 years, 10 years, 20 years, and even 30 years). Like a conventional mortgage, a portion of the loan payments comprise the principal and the interest.
Pros of Home Equity Loans
- Home equity loans are a great way to enable the equity that’s built through consistent mortgage payments in a home to be converted into cash. This is useful for reinvesting the loan to boost the overall value of the home.
- The fixed interest rates for home equity loans are typically lower than other types of loan products and credit cards, making them a great choice
- Taking out a home equity loan enables borrowers the option of paying off the loan before its terms complete, then refinancing the loan at a lower rate to pay off the previous loan with a higher interest rate. Bear in mind that this requires that the borrower must submit to another credit approval process (similar to the initial mortgage) and may be subject to fees associated with booking a new loan.
Cons of Home Equity Loans
- If the home equity loan isn’t repaid and proceeds into default, a homeowner may lose their home to satisfy the remaining debt. This can lead to foreclosure and destroy a person’s credit, so care must be taken when deciding on a home equity loan.
- If the value of real estate drops, the appraised value of the house could also follow suit and may cause borrowers to ultimately owe more than the home is actually worth.
What is a Home Equity Line of Credit (HELOC)?
Essentially, a home equity line of credit (HELOC) is a revolving credit line that enables borrowers to take out cash against the line of credit up to a predetermined limit. HELOCs can be used to tap into as needed, which differs from the lump-sum payments of a home equity loan. In this fashion, a HELOC functions more like a credit card which is secured by the equity in a home.
Because a borrower can borrow based on their needs, the line of credit is open until the end of the draw period (see below) and closing at the start of the repayment period. Consequently, a borrower’s monthly minimum payments change based on the use of the credit line.
The Terms and Loan Collateral of a HELOC
Like a home equity loan, a HELOC is backed by the equity in a borrower’s home. And because a HELOC is secured by the home, if payments aren’t made on time, the borrower could lose their home.
A key difference between a HELOC and a home equity line of credit is that HELOCs come with a variable interest rate. This means that monthly payments are not consistent, increasing or decreasing each year. However, there are lenders who offer HELOCs at a fixed rate of interest.
Draw Period and Repayment Period of a HELOC
HELOCs have another feature: Two periods for the terms of the loan.
The first period is known as the draw period, which is the time frame in which a borrower has the ability to withdraw funds. This period may last 10 years. Once this period is over, borrowers cannot withdraw any more credit.
The second period is the repayment period. This repayment period could last 20 years after the draw period, ultimately making the HELOC a loan with a 30-year term. Borrowers in the repayment period typically only make payments on the interest. Because of these interest-only payments, monthly payments during the repayment period can be substantially higher than those during the draw period.
Pros of HELOCs
- With a HELOC, borrowers have a clear idea of the maximum amount of cash they can borrow, which is the amount of the credit limit.
- HELOCs offer a measure of flexibility compared to other loan sources. Borrowers make the choice to borrow as much as needed up to the credit limit.
- If a HELOC has been borrowed from, the outstanding balance can be refinanced into a home equity loan with a fixed-rate. This works by the lender issuing a new loan to pay off the original HELOC (which closes the line of credit by using the proceeds to cover the outstanding balance). This would require the borrower to wait for their credit to be looked at during the subsequent approval process, but this can be a reasonable failsafe if the HELOC becomes unmanageable.
Cons of HELOCs
- The variable interest rate can rise, which makes HELOCs difficult for those to budget for - especially those that plan to live on a fixed income in the future.
Should You Get a HELOC or a Home Equity Loan?
Both home equity loans and home equity lines of credit allow homeowners to gain access to funds stored in the equity of their home. What is the better choice?
The best way to choose between each type of equity-based loan is to determine the reason for the loan/line-of-credit. A home equity loan is good for those that need a lump-sum payment for a large purchase, such as remodeling the home, as adding to a college fund, or consolidation debt through refinancing.
On the other hand, HELOCs are useful for those that want the flexibility to borrow as much as or as little as they need. This enables borrowers the ability to pay for unexpected expenses. For example, if a homeowner intends to renovate a home for sale but discovers additional issues with the house, the line of credit can be drawn from continuously up to the credit limit while it is in the draw period.
Bear in mind that just because a homeowner has the ability to borrow against their home’s equity, they may want to pursue other funding sources. Having a clear plan required considering the many factors of borrowing against a home’s equity, such as how the money will be used, interest rate fluctuations, long-term financial plans, and other associated risks.