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- Home equity loans and HELOCs allow you to borrow against the value of your home.
- Both are types of second mortgages, but they differ in how you can access your funds and how you'll repay them.
- You can typically borrow up to 80% or 90% of your home's value, minus the balance of your first mortgage.
If you need to borrow against the equity you have in your home, a second mortgage may be the best way to do so.
Interest rates are often lower on second mortgages than other borrowing options, such as online personal loans or credit cards. Plus, in a high-rate environment, a second mortgage is typically preferable to getting a cash-out refinance and potentially taking on a significantly higher rate on your first mortgage.
Home equity lines of credit (HELOCs) and home equity loans are two types of second mortgages that let you borrow against the equity you have in your home. But these two home equity products don't work in the same way. The best fit for you depends on your needs.
Understanding home equity loans
Home equity loans and HELOCs both allow you to borrow against your home's equity, and you can use the funds however you'd like. It's common for borrowers to use second mortgages to pay for things like home repairs or upgrades.
But the way you'll have access to the funds and repay them differs depending on the type of second mortgage you get.
What is a home equity loan?
Home equity loans let you borrow against the equity in your home and receive your funds in a single lump sum. You'll then pay it back — plus interest — monthly over the course of your loan term (usually anywhere from five to 30 years).
How home equity loans work
Like personal loans, home equity loans come with a fixed interest rate and fixed repayment term. Because of this, you'll also get a fixed monthly payment that doesn't change during the life of the loan. Home equity loans are extremely predictable; you know how much you're borrowing, how long it'll take you to pay it back, and exactly how much you'll owe each month.
You'll start making monthly payments on a home equity loan as soon as you close on the loan.
Key features of home equity loans
Home equity loan amounts are typically limited by your loan-to-value ratio, or your home value minus your existing mortgage balance. Typically, you'll be able to get a home equity loan up to 80% or 90% of your home's value, minus your current mortgage balance.
There are usually closing costs with home equity loans, so find out from your lender how much you'll be expected to pay before closing. Different home equity loan lenders have different fee structures — some have very low fees — so you'll want to compare your options.
In some cases, lenders may charge a prepayment penalty, so make sure to read the fine print in case you want to pay back the loan ahead of schedule.
Understanding HELOCs (home equity lines of credit)
HELOCs — or home equity lines of credit — are another tool you can use to borrow from your home's equity, though they work a little differently than home equity loans.
What is a HELOC?
Where home equity loans function similarly to a personal loan, home equity lines of credit, or HELOCs, work similarly to a credit card.
Instead of giving you a lump sum, a HELOC is a line of credit you can borrow against when you need the money. As such, you will only repay amounts of money you borrow in the end.
Their flexibility makes HELOCs a good option if you're working on an open-ended project and aren't sure exactly how much you'll need overall.
How HELOCs work
HELOC repayment is split into two periods: the draw period and the repayment period. Often, a HELOC draw period will last 10 years and the repayment will be spread out over 20 years, but term lengths can vary.
You'll only be able to take money out during the draw period. Some HELOC lenders have minimum withdrawal requirements, but aside from that, you'll have the freedom to borrow only what you end up needing — meaning you'll only pay interest on the amount you borrow.
During the draw period, you'll generally make interest-only payments. Once the repayment period begins, you'll no longer be able to make withdrawals from the HELOC, and you'll start making monthly payments that include both the principal and interest.
Key features of HELOCs
Like home equity loans, HELOCs usually limit your borrowing ability to up to 80% or 90% of your home's value, and may or may not include fees depending on the lender. They typically come with a variable interest rate, which can make your monthly payment amount hard to predict.
Some lenders offer the option to convert part of your balance to a fixed mortgage rate, so be sure to ask about this possibility when shopping for your loan.
Pros and cons of home equity loans
Both home equity loans and HELOCs have their advantages and drawbacks. Here are the ones to consider before getting a home equity loan.
Pros of home equity loans
The biggest benefit is that home equity loans have fixed interest rates and monthly payments. This can make them easy to budget and plan for.
You can also use the money for anything, and you'll get to spread it out over an extended period of time to make it more affordable.
Depending on what you use the funds for, you also might qualify for a tax deduction when you take out a home equity loan.
Cons of home equity loans
The main drawback of these loans is that they use your home as collateral, so if you don't make your payments, the lender can foreclose on your house.
They also come with closing costs and add a second monthly payment to your household (in addition to your first mortgage payment).
Pros and cons of HELOCs
Before you take out a HELOC, weigh these pros and cons first.
Pros of HELOCs
HELOCs are great because you can withdraw money over time as you need it. You can also pay some back, borrow more, and repeat for as long as your draw period lasts.
Best of all, you only pay interest on what you borrow, rather than a full lump sum — as with a home equity loan.
Often, HELOCs have no closing costs or upfront fees. Their variable rates can sometimes be lower than fixed rates too — at least at the start of the loan term.
Cons of HELOCs
As with home equity loans, you're using your home as collateral with a HELOC, so you risk foreclosure if you don't make payments.
They also typically have variable rates, which can make budgeting hard, and they may require a larger balloon payment or lump sum at the end of your draw period.
Comparing HELOCs and home equity loans
HELOCs and home equity loans are pretty similar, but they have a few key differences, too. These include:
Flexibility and accessibility
Both are flexible in that you can use the funds for any purpose, but HELOCs offer added flexibility by allowing you to withdraw additional funds over time. You can also repay your balance, and then borrow more later on. Home equity loans have a single lump sum and that's all.
Interest rates and terms
HELOCs usually have variable interest rates, so your payments and rate can fluctuate. You'll also have 10 years to withdraw money and 20 to pay it back.
Home equity loans almost always have fixed interest rates, meaning you'll always have the same rate and monthly payment. Their terms range anywhere from five to 30 years.
Repayment options
With HELOCs, you make interest-only payments during the draw period, then pay principal and interest during the repayment period. With home equity loans you'll start making monthly principal and interest payments immediately after closing on the loan.
Uses and financial goals
Both options can be used for any purpose or goal. Many homeowners use them to pay for home repairs or renovations.
Since they tend to have lower rates than personal loans and credit cards, they can be good options for consolidating debt, too.
Which option is right for you?
Both home equity loans and HELOCs can be good options if you're a homeowner in need of cash. Here's how to determine which is the best for you.
Factors to consider
You should think about what you'll use the funds for before deciding which route to go. If you have a fixed, predictable amount you need to cover, a home equity loan and its lump sum could be a good option. If you're not sure how much you need or want access to funds over a longer period, a HELOC is likely best.
Consider the interest rate, too — and how it fits into your budget. If you want a fixed monthly interest rate and a fixed payment, a home equity loan is a better option. If you don't mind a variable interest rate and have the funds to comfortably handle any increase in payment, a HELOC might be better.
Financial situation and goals
Keep in mind the repayment models, too, and figure out which fits with your household's financial situation best. For example, if you need a low monthly payment right now, but can afford larger ones later on, a HELOC may be the better fit. If you can afford a larger payment now, a home equity loan could be best — especially if you want a payment that won't fluctuate.
Risk tolerance
You should also consider the risk of borrowing from your home's equity, regardless of the type of loan you use. If you default on your second mortgage, the lender may foreclose and you could lose your house. Getting a home equity loan or HELOC isn't necessarily a bad idea, but it's important to consider what's at stake when you take out a loan on your home.
FAQs on HELOC vs Home Equity Loan
A HELOC is a revolving credit line you can withdraw from over a period of 10 years, while a home equity loan provides a lump sum.
HELOCs often have variable rates, which can change over time, while home equity loans typically have fixed rates.
Yes, both HELOCs and home equity loans can be used for various purposes like home improvements, debt consolidation, or major expenses. There are no restrictions on what you can spend the funds on.
To qualify for a HELOC, you'll need a solid amount of home equity, a good credit score, and the income to afford a second monthly payment. Exact requirements vary by lender.
