Home Equity Loan vs HELOC: What’s the Difference?
If you’re looking to access your home’s equity, you should be considering home equity loan vs HELOC. Read on for a full comparison of both options.
Equity is a common motivator for buying a home. Instead of losing all of your monthly housing payments to a landlord, you pay off a mortgage and in turn gain the value of your home as a personal asset. That value is your home equity.
Home equity is the value of your home minus the outstanding balance you still owe on your mortgage loan. And if you need cash, you can tap into it.
If you’re interested in learning more about this process, check out our blog on using HELOC to pay off mortgage.
People tap their equity for a number of reasons, often to consolidate debts and reduce the number of payments they make each month. Some people choose to tap their equity to renovate their home and increase its value, while others invest in a second piece of real estate using the equity in their first homes as down payments.
There are many other ways why a person might choose to access equity, but only a few ways to get that access. Two of the most well-known are the home equity loan and the home equity line of credit, or HELOC.
What Are Home Equity Loans and HELOCs?
Home equity loans and HELOCs are lending products that let you liquidate your equity. Essentially, you turn a portion of your home’s value over to a lender. The lender gives you the approved value’s cash equivalent, which becomes the amount that you have to repay.
HELOC vs Home Equity Loan: The Similarities
Home equity loans and HELOCs both let you borrow against your equity with the property as collateral, so they share several basic features.
1. Comparatively Low-Interest Rates
Because they both involved borrowed money, home equity loans and HELOCs require interest payments. Fortunately, the interest rates for both products are usually lower than those associated with credit cards or personal loans.
2. Borrowing Limits
In both cases, you won’t get approved for the total amount of your equity. Your lender will probably cap your borrowing at 80 percent to 95 percent of what you’ve built up. The exact percentage depends on your finances and your lender’s risk tolerance.
3. Default Risks
Both products function separately from your initial mortgage, which means that you’ll have two home loans to pay back instead of just one. And because your home is your collateral on a home equity loan or HELOC, you could face foreclosure if you default on either loan.
You also face the possibility that if you tap equity and then your home declines in value, you could end up owing more than your home is worth.
4. The Good News
There are never any restrictions on how you use the money from a HELOC vs home equity loan. As a homeowner, you just have to pay it back on time.
HELOC vs. Home Equity Loan – The Differences
The difference between a home equity loan and a line of credit lies primarily in their basic borrowing structures, but the repayment terms tend to differ as well. Here are the most important variances.
1. How You Borrow
A home equity loan works like a second mortgage. You get approved for a certain amount and when you sign the contract, that money goes into your account in a lump sum. You then make a monthly payment until you’ve paid back the full amount you borrowed, plus interest.
A HELOC works more like a credit card in that you get approved for a particular amount, but you don’t have to borrow it all at once. You have a maximum total available to you and can borrow against it as you will, provided that you continue to repay the outstanding balance according to the terms of the lending agreement.
2. When You Repay
When you take out a home equity loan, you start paying it back right away. You keep making monthly payments as scheduled until it’s paid off.
A HELOC is different. You start the lending relationship in a draw period, during which time you can borrow against your limit. As a borrower, you’ll also make some payments during this time, but whether you pay interest only or interest and principal depends on your loan term and structure.
Most draw periods last 10 years and most repayment periods last up to 20 years, but lenders have the flexibility to set their own terms.
3. Interest Rate Structure
A home equity loan is a fixed-rate product, so your interest rate stays the same throughout the life of the loan. The upside of a fixed-rate loan is that you can expect consistent monthly payments, but you might pay a higher interest rate for the privilege.
A HELOC usually has a variable rate based on a market index. If the index rises, so will your interest rate and your monthly payment. On the other hand, if it drops your variable interest rate will be lower and you’ll pay less.
4. Flexibility of Fees
Just like a first mortgage, home equity loans can have closing costs. You can expect that initial cost to be between 2 percent and 5 percent of your loan amount. You may also have to pay an early termination fee if you prepay your mortgage loan.
Some HELOCs also come with fees, but it’s much more common for a lender to waive or reduce them. If you have a lower interest rate initially, you could end up paying much less to get that loan going on your home’s equity.
Alternatives to Home Equity Lending
If you’ve weighed a home equity line of credit vs. a home equity loan and you’re not sure that either is right for you, don’t worry. There are alternatives for a homeowner.
You can sell your house, of course, but traditionally that means you won’t get your home’s equity until you close. If you need equity right away, whether for personal use or to make a down payment on another property, that might not work.
A sale-leaseback program allows you to convert your equity to cash by selling your home. You remain in place as a tenant and use the equity however you will.
A sale-leaseback isn’t a loan, so there’s no interest payment and no risk of foreclosure. You simply keep paying rent throughout the repayment period until you’re ready to repurchase your home or relocate, according to the terms of your agreement.
A sale-leaseback works well for people who aren’t sure if they really want to move – or are fairly sure that they don’t.
If you want to convert your equity but don’t want to take on another loan and the interest payment that goes with it, consult with your financial advisor to explore your options.