How to Compare Home Equity Loans and HELOCs

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Reviewed byTimothy Manni
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Updated: March 5, 2024

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Using your home's equity can be a smart way to handle big expenses, but choosing the right method is crucial. Both home equity loans and lines of credit (HELOCs) allow you to borrow against your home's value. They share a similarity: using your home as collateral. Understanding the difference between a home equity loan and a line of credit is key. We laid out both options, highlighting their unique features. You'll learn when each option is most beneficial and how your choice impacts your finances, helping you make informed decisions for your financial future.

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What Is a Home Equity Loan?

A home equity loan, sometimes called a second mortgage, lets you borrow money using your home's value minus what you owe on your primary mortgage. The amount you can borrow depends on your home equity. Like most financing options, they have an interest rate, which represents the cost of borrowing the funds. These rates are often lower than what you'd get with personal loans or credit cards. Once approved, you get the loan as a lump sum. You then pay it back in fixed monthly payments, making budgeting easier, as you'll know exactly what you owe each month.

HOW TO DETERMINE YOUR HOME’S EQUITY

Home equity is the difference between your home's market value and the amount you owe on your mortgage. To calculate home equity, subtract your mortgage balance from your home's current value. For example, if your home is worth $300,000 and you owe $200,000, your equity is $100,000. Knowing your home equity is crucial before considering a loan or HELOC, as it determines how much you can borrow.

What Is a Home Equity Line of Credit?

A home equity line of credit, or HELOC, differs from a traditional loan as it offers flexibility in borrowing and repaying. Instead of getting a lump sum, it works like a credit card tied to your home's equity. You have a credit limit and can borrow as needed within the draw period, which usually lasts 10 years. During this time, you can borrow, repay and borrow again up to your limit. After the draw period ends, the repayment period begins. Now, you can't borrow more and must start paying back what you've borrowed, often with interest.

Home Equity Loan vs. HELOC: What’s the Difference?

Both home equity loans and HELOCs are secured loans, with your home acting as collateral. If you can't keep up with payments, you risk losing your home. These might offer lower interest rates compared to unsecured loans, but it also means you need to be cautious and confident you can meet the repayment terms.

Despite these similarities, there are key differences between home equity loans and HELOCs. For instance, the former gives you a lump sum with a fixed interest rate, while a HELOC works like a credit card with a variable rate, allowing you to borrow as needed. Understanding these differences may affect your choice depending on your financial situation and needs. Some might prefer the stability of a home equity loan, while others might favor the flexibility of a HELOC. Your decision should align with your financial goals and ability to manage repayments.

Lender Requirements

When applying for either a home equity loan or a HELOC, lenders have specific requirements you'll need to meet. They use these to determine whether or not you're a reliable borrower. Here's what they typically look for:

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Remember, specific home equity loan requirements can vary between lenders. It's a good idea to shop around and compare what different ones offer. This way, you can find the best deal for your financial situation. Stay informed and choose wisely to make the most of your home's equity.

Tax Implications

Both home equity loans and HELOCs can have tax implications, particularly regarding interest deductions. Under certain conditions, you might be able to claim a tax deduction from the interest you pay. According to the Tax Cuts and Jobs Act, the interest is only deductible if the loan is used to buy, build or substantially improve the taxpayer's home (and it must be the one securing your loan). Using the funds for other purposes, like debt consolidation or personal expenses, won't qualify for the deduction.

Given the complexity of tax laws, talking to a tax professional is essential. They can provide personalized advice based on your specific situation, ensuring you understand the tax implications of a loan or line of credit. Remember, getting expert advice can make a big difference in your financial planning.

Closing Costs

Both home equity loans and HELOCs come with closing costs, but they can vary. Understanding these costs is key as they affect the total cost of your loan. Typical home equity loan closing costs include appraisal, attorney and title search fees. HELOCs might have similar fees but are often lower. Some lenders offer 'no-closing-cost' options. Although they can be attractive, the costs are usually rolled into your loan, potentially increasing your overall repayment amount.

When considering closing costs, it's smart to shop around. Different lenders have different fee structures, so comparing them can save you money. Remember, the lowest closing costs don't always mean the best deal. Look at the entire loan package to make an informed choice.

Interest Rates

A major difference between home equity loans and HELOCs is how the interest rates work. Those for home equity loans are usually fixed. Your rate and monthly payments stay the same throughout the loan, making budgeting easier. In comparison, HELOCs typically have variable rates. Your payments can change based on market conditions, which adds an element of unpredictability to your budget.

However, some HELOC lenders offer a fixed-rate option. These are less common but can provide more stability in your repayments. Some lenders also allow you to convert a portion of your HELOC balance to a fixed rate during the draw period.

When searching for competitive rates, it's wise to shop around and compare offers from multiple lenders. Look at the annual percentage rate (APR), which includes the interest rate and other fees, to get a true sense of the loan's cost.

Funds Disbursement

When comparing home equity loans to home equity lines of credit, how you access your funds is a key consideration. With the former, you receive the entire amount as a one-time lump sum. It's an excellent choice if you have a specific, considerable expense you need to cover right away.

A HELOC works more like a credit card. You have a set limit, but you only borrow what you need during the draw period, which usually lasts several years. This flexibility can be helpful for ongoing expenses, like home renovations, where you might not know the total cost upfront.

It's important to spend wisely, regardless of the option you choose. Borrowing against your home's equity is a significant financial decision. Responsible spending and sticking to your budget are crucial to avoid financial strain down the line.

Repayment

Repayment is another area where home equity loans and HELOCs differ. Home equity loans have fixed monthly payments, making it easier for borrowers to plan their finances, as they pay the same amount every month. On the other hand, HELOCs offer more flexibility. During the draw period, you may only need to pay interest. However, once it ends, you start repaying both interest and principal, which can increase your monthly payments considerably.

Managing these payments requires careful planning. Here are some strategies:

  • Budget Adjustment: Carefully review your income and regular expenses and allocate a specific part of your budget for loan repayments. This is especially important for HELOCs, where payments can increase after the draw period ends. A well-planned budget ensures you consistently meet your repayment obligations without overstretching your finances.

  • Extra Payments: When you have extra funds, consider making additional payments towards your loan. It reduces your principal balance faster, lowering the total interest accrued. For fixed-rate home equity loans, extra payments can shorten the loan's lifespan and save you money in the long run. Even infrequent extra payments can have a significant impact on reducing your loan term.

  • Refinancing: Keep an eye on interest rate trends. If rates drop, refinancing your loan might result in lower monthly payments or a shorter loan term. For HELOCs, refinancing might also offer the opportunity to switch to a fixed-rate loan, which can provide more payment stability.

  • Avoid Additional Debt: Focus on repaying your current home equity loan or HELOC before taking on new debts. Additional obligations can strain your financial situation and make it harder to manage variable HELOC payments. Keeping your debt-to-income ratio low is crucial for maintaining good financial health.

  • Emergency Fund: Aim to build an emergency fund that can cover several months of living expenses, including loan payments. It acts as a financial safety net during unforeseen circumstances, like job loss or emergency expenses. Having this buffer is crucial to ensure you can continue making loan payments and protect your home from potential foreclosure risks.

Defaulting on a HELOC or home equity loan carries serious risks, including losing your home. Choosing a loan that fits your financial situation is a game-changer, and so is managing your repayments responsibly. Remember, these two financing options offer different benefits and drawbacks, and the right choice depends on your personal needs and financial habits.

Home Equity Loans vs. HELOC: Which Is Best?

Choosing between home equity loans and HELOCs is essential because each suits different financial situations. Selecting the wrong one could mean higher costs or payment schedules that don't align with your budget, leading to financial strain.

Remember, the best choice between home equity loans and HELOCs depends on your unique circumstances. Making an informed choice can help you leverage your home’s equity in the most beneficial way.

When to Get a Home Equity Loan

Knowing when a home equity loan is more suitable than a HELOC can help align your financial needs with the right borrowing option. It ensures you manage your debts effectively and avoid unnecessary financial stress. Scenarios where a home equity loan is a better choice include:

1

You Know the Exact Amount You Need

If you have a specific, significant expense, like a major home repair or a one-time medical bill, a home equity loan is ideal. They provide a lump sum, so you'll have the exact amount you need right away.

2

Debt Consolidation Without New Credit Lines

A home equity loan can be a smart move if you're consolidating debt, like paying off high-interest credit cards. It offers a one-time influx of cash without the temptation of an open line of credit, reducing the risk of accruing more debt.

3

Stable Monthly Payments on a Fixed Income

A home equity loan with predictable monthly payments is suitable if you have a fixed income, such as a steady salary or retirement benefits. This ensures your payments don't fluctuate, making budgeting simpler and more reliable.

Understanding this enables you to leverage your home's equity effectively, aligning with your financial goals and circumstances.

When to Get a HELOC

Understanding when a HELOC fits your financial situation helps you utilize your home's equity in the most flexible and efficient way. Knowing when to get a HELOC can help you plan better and avoid financial products that don't match your spending habits or future plans. Scenarios where a HELOC might be the better option include:

1

Need for a Revolving Credit Line

A HELOC is ideal if your expenses vary or are spread out over time, like ongoing home renovations or education costs. You can borrow what you need when you need it, giving you flexibility and control over your borrowing.

2

Credit Line for Future Emergencies

If you want to have funds available for unforeseen circumstances but don't need cash immediately, a HELOC is a wise choice. It's like having a financial safety net that you can tap into only when necessary.

3

Deliberate Spending and Budget Control

If you're disciplined in your spending and comfortable with a variable budget, a HELOC may suit you well. They allow you to borrow and repay flexibly, making it a good match for those who can manage the variable nature of the credit line and its payments.

Remember, a HELOC is an excellent choice for those with fluctuating expenses or who prefer having credit readily available when it’s truly needed.

MONEYGEEK EXPERT TIP

Whether you choose a home equity loan or a home equity line of credit, using the funds to improve your home gets you the most bang for your buck. You're improving your living space and increasing the value of your home, and the interest you pay is tax deductible. — Timothy Manni, Mortgage and Real Estate Consultant

FAQ: Comparing Home Equity Loans to HELOCs

Our FAQ section provides you with additional insights, helping you better understand how home equity loans and HELOCs compare and which might be the best fit for your needs. Whether you're curious about borrowing speeds, repayment terms or the impact of fluctuating home values, these questions cover various topics to aid your decision-making process.

Both home equity loans and HELOCs generally have similar processing times, often ranging from a few weeks to a couple of months. The speed can vary based on the lender and your personal financial situation.

Yes, it's possible to have both a HELOC and a home equity loan, but it depends on your lender and your financial situation. Your home equity serves as collateral for both, so you must have enough in your home to support both.

Funds from home equity loans and HELOCs can be used for a variety of purposes, including home improvements, medical bills, debt consolidation or education expenses. The key is to use the funds responsibly, as your home is collateral.

The amount you can borrow typically depends on your home's equity, financial health and the lender's policies. Generally, lenders allow you to borrow up to 80% to 85% of your home's appraised value minus any existing mortgage.

Lenders prefer good to excellent credit scores, but some may be willing to work with homeowners with lower scores, albeit at higher interest rates and with stricter terms.

Yes, it's possible to refinance a home equity loan into a HELOC and vice versa. This decision should be based on your current financial needs, interest rates and market conditions.

Fluctuating home values can affect the amount you can borrow, as both loans are based on your home's equity. A significant drop in home value could also lead to issues like owing more than your home's worth.

When you sell your home, you must pay off the outstanding balance of any home equity loan or HELOC. The proceeds from the sale are typically used to pay off these debts before you receive any remaining funds.

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