Homeowners have seen their home’s equity increase by record amounts in recent years. There are two popular ways to unlock that equity right now: a home equity loan and a home equity line of credit, or HELOC.
Both products allow you to borrow against your home equity without disturbing your primary mortgage. Home equity loans and HELOCs also tend to have lower interest rates than other borrowing methods -- like personal loans or credit cards.
“We are seeing record demand for our loans as many borrowers seek to use home equity loans to increase the value of their home with a home renovation or consolidate outstanding variable rate debt,” says Rob Cook, vice president of marketing, digital, and analytics for Discover Home Loans.
Borrowing with either a home equity loan or HELOC comes with a serious risk: losing your home. Both products are secured by your home. So, if you default on payments, your lender can repossess your home.
The major differences between a home equity loan and a HELOC are the type of interest rate, how the funds are disbursed and how to repay your loan. Read on to learn more about each of these home loans to determine which is the right fit for you.
How to calculate home equity
Calculating your home equity is simple: Take the difference between what you owe on your mortgage and the current appraised value of your home.
Once you have an up-to-date appraisal, look up your outstanding mortgage balance and subtract it from the appraised value. If, for example, your home is currently worth $375,000 and you have $200,000 left to pay on your mortgage, then you have $175,000 of equity in your home, or 47%.
$375,000 – $200,000 = $175,000 (47% equity)
What is a HELOC?
A HELOC functions like a credit card and allows you to borrow against the equity you’ve built in your home. It provides a revolving line of credit that you can access for a certain amount of time, which is called the draw period. The duration of the draw period is usually 10 years. One of the benefits of a HELOC is that you’re only required to pay back the interest on money you’ve withdrawn, so you can borrow a large amount for an extended period of time while only making minimum monthly payments.
HELOC: Pros and cons
HELOCs typically have variable interest rates, which isn’t necessarily advantageous in today’s economic climate. Unlike mortgages, HELOC rates are directly tied to an index -- the prime rate -- that moves in lockstep with the federal funds rate. When the Federal Reserve hikes rates -- which it’s done eight times since March 2022 -- it becomes more expensive to borrow with a HELOC.
However, a HELOC offers more flexibility than a home equity loan.
Pros
- Interest-only draw period: During your draw period, you don’t have to make payments on your principal loan balance. Instead, you can make minimum payments on just the accrued interest. That keeps your monthly payments extremely low for the first decade of your loan.
- Long repayment period: A HELOC offers long repayment terms, usually up to 30 years. However, once your draw period ends and your repayment period begins, you cannot withdraw any more funds, and your monthly payments will jump up because you have to start making payments on your principal balance, too, so be prepared for possible sticker shock when your bill arrives.
- Flexible access to funds: You can make withdrawals whenever you need, for whatever you need. Some lenders will have minimum withdrawal amounts, or a maximum number of withdrawals you can make during your draw period, but they should be more than enough for the average homeowner.
Cons
- Variable interest rate: A variable interest rate can be a disadvantage during an economic environment such as the one we’re currently in. As interest rates continue to rise, it means that your HELOC rate will rise too, making your monthly payments more expensive. However, some lenders offer fixed-rate HELOCs -- an option worth considering if you want the stability of a fixed monthly payment.
- Interest-only draw period: While low monthly payments during the beginning of your loan may sound appealing, the drawback is that you aren’t making a dent in your principal balance for years while also accruing interest. So if you just make interest-only payments during your draw period, you will still have a huge sum to pay off once your repayment begins.
- Your home is used as collateral: Putting your home up for collateral is no small consideration. When your home is the collateral that secures your loan, it means your bank or lender can repossess your home if you miss payments. Putting yourself at risk of losing your home to foreclosure is a choice that may not be wise for every homeowner or for people who’ve had issues paying back loans in the past.
What is a home equity loan?
A home equity loan gives you a lump sum of cash at a fixed interest rate and a fixed repayment schedule. You make monthly payments on your full loan amount plus the interest from the very beginning of the loan, and your payments and interest rate do not change over the loan term, whether it’s 10, 20 or 30 years. A home equity loan doesn’t replace your mortgage like a refinance -- it’s a brand-new home loan that you must repay monthly along with your existing mortgage payment.
Home equity loan: Pros and cons
A home equity loan has a fixed interest rate, which is ideal in a rising interest rate economy, but it’s also less flexible than a HELOC and has its downsides to consider.
Pros
- Fixed interest rate: Your rate is locked in, so even if interest rates rise (as is expected) you’ll get to keep your lower rate, saving you thousands of dollars over the lifetime of your loan.
- Predictable monthly payments: Because your interest rate doesn’t change, your monthly payment won’t either. Predictable payments may be appealing to many homeowners right now, given the current economic uncertainty and a potential recession on the horizon. A home equity loan can help minimize surprises to your budget, compared with a variable rate HELOC.
- Tax-deductible interest: When you use your home equity loan for home renovations or additions, the interest is tax-deductible, saving you thousands of dollars. In addition, you’re increasing your property value while enjoying the investment in your home.
Cons
- Lack of flexibility: Because a home equity loan only gives you one lump sum of cash upfront, it’s more limiting than a HELOC, which gives you the ability to make repeated withdrawals over the years. It also means that you have to pay interest on the total amount of your loan for the entire time you’re borrowing the money, adding interest to your bill (which isn’t the case with an interest-only HELOC).
- Your home is used as collateral: Home equity loans have lower rates because they are secured loans, which means your property serves as collateral for your loan. When you put your property up as collateral, it means your bank or lender can take ownership to pay themselves for your loan if you don’t, so it’s critical to never miss payments.
- Cost of borrowing is high: Even though homeowners have seen their home equity increase by record amounts -- and loans still have lower interest rates than other types of financing such as personal loans or credit cards -- the cost of borrowing money has still soared and is at its highest rate since 2008.
HELOC vs. home equity loan: Which is better?
Whether a HELOC or home equity loan is right for you depends on your specific financial needs. If you need to make repeated withdrawals over a long period of time for an expense, such as college tuition, then a HELOC with an extended repayment and interest-only draw period may be the better option for you. If you need a lump sum of cash for a one-time expense, such as consolidating credit card debt, a home equity loan of credit might make more sense.
“If a homeowner is unsure of the amount of money they need, then they may be better off with another loan option such as a HELOC,” Cook says.
Keep in mind, borrowing with either a home equity loan or HELOC comes with a major risk: losing your home. Because these loans are secured by your property, if you default on payments, your lender could repossess your home.
HELOC rates vs. home equity loan rates: What’s the difference?
The average rate for a HELOC is 7.76%, while the average rate for a home equity loan is 8.00% -- according to CNET’s sister site Bankrate. Rates for each have been rising since the beginning of the year, in line with interest rate trends overall. Home loans still have lower financing rates than personal loans, for which the average is 10.81%, according to Bankrate.
Keep in mind, however, that HELOCs have variable interest rates, so your rate will rise and fall over time in response to the changing economic climate, making your monthly payments inconsistent. In comparison, your home equity loan payments will be the same each month for the lifetime of your loan because it has a fixed interest rate that will never change.
How much home equity can you use?
Lenders typically want to see that you have at least 15% to 20% equity in your home before you borrow money against it. Most lenders will allow you to borrow around 75% to 90% of your loan-to-value ratio, or LTV ratio, which is your outstanding mortgage balance divided by your home’s current appraised value. The fastest way to build up home equity is to make a large down payment and make consistent, on-time mortgage payments over the years.
The bottom line
Whether a HELOC or a home equity loan is the right type of financing for your loan depends on whether you need all of your money at once or spread out over time. Both types of loans are secured by a collateral: your home. If you fail to make your payments, you could lose your home. Home equity loans have fixed interest rates while HELOCs tend to have variable interest rates.
