Understand Which Loan Option Is Right for You—Home Equity Loans vs. Line of Credit (HELOC)
April 6, 2023
7 min read
Homeownership can be a valuable asset and source of financial stability for many individuals and families. As you continue to pay off your mortgage and build equity in your home, consider using that equity to finance other expenses or investments.
Home equity loans and lines of credit (HELOCs) are widely used for accessing the value of your home. However, despite being sometimes used interchangeably, these are two distinct types of financing, each with unique features, advantages, and drawbacks.
To make informed decisions regarding your financial future, it's vital to grasp the distinctions between home equity loans and HELOCs. In this article, we will delve into the critical differences between these two types of financing and aid you in assessing which option is most appropriate for you.
Home Equity Loans
Essentially, a home equity loan enables homeowners to borrow funds by using the value of their home as collateral. The amount of equity available is calculated by subtracting the mortgage's outstanding balance from the property's assessed value. These loans are sometimes referred to as second mortgages, as they exist in addition to the primary mortgage.
Home equity loans are usually distributed as a single lump sum payment, which can be repaid over a specific term at a fixed interest rate. Home equity loans often have better interest rates than others, and the interest paid may be tax-deductible.
Advantages
One of the main advantages of a home equity loan is the predictability of payments, as borrowers know how much they need to repay and when they will pay off the loan. Home equity loans also offer a quick source of cash for large expenses, such as home repairs, college tuition, or debt consolidation.
Disadvantages
However, there are some disadvantages to home equity loans as well. One of the biggest risks is that borrowers may risk their homes as the property secures the loan. Additionally, borrowers must have sufficient home equity to qualify for a home equity loan.
Typical Uses of Home Equity Loans
Typical uses of home equity loans include home improvement projects, debt consolidation, and large expenses, such as medical bills or unexpected emergencies.
Qualifications for a Home Equity Loan
To be eligible for a home equity loan, certain criteria must be met, including a good credit score, stable income, and adequate equity in your home. The amount you can borrow depends on your creditworthiness, the appraised value of your home, and the lender's criteria.
Line of Credit (HELOC)
A line of credit or HELOC is another type of loan allowing homeowners to borrow against their home equity. However, unlike home equity loans, HELOCs are revolving lines of credit, similar to credit cards. This implies that you can access funds as needed, up to a pre-set credit limit, and pay interest solely on the amount borrowed.
HELOCs generally come with fluctuating interest rates, implying that the interest rate can vary over the loan's duration. This can be an advantage or disadvantage, depending on the direction of interest rates. Also, HELOCs may have a draw period, during which you can borrow funds, followed by a repayment period, during which you must repay the borrowed amount.
Advantages
One of the main advantages of HELOCs is their flexibility. Borrowers can borrow funds as needed and only pay interest on the amount borrowed, making HELOCs a useful financing option for ongoing expenses, such as home renovations or college tuition. Also, HELOCs may have lower closing costs and fees than home equity loans.
Disadvantages
However, HELOCs also come with some risks. Since the interest rate can change, borrowers may face unexpected monthly payment increases, making budgeting difficult. Additionally, HELOCs are also secured by the borrower's home, so there is a risk of foreclosure if payments are not made.
Typical Uses Of HELOC
Typical HELOC uses include home improvement projects, ongoing expenses, and emergencies.
How to Qualify for a HELOC
For a borrower to be eligible for a HELOC, they must possess a good credit score, stable income, and adequate home equity. The maximum amount is contingent on the borrower's creditworthiness, the appraised value of their property, and the lender's prerequisites.
Key Differences Between Home Equity Loans and HELOC
Although both utilize the equity in your home to secure the loan, home equity loans and HELOCs have unique attributes that are important to comprehend before making a decision.
1. Interest Rates and Payment Terms
Distinguishing features between home equity loans and HELOCs involve their interest rates and payment conditions. Home equity loans have a steady interest rate and a fixed repayment term, ensuring that the borrower knows how much they must pay each month and how long it will take to repay the loan.
Conversely, HELOCs come with a variable interest rate and a flexible repayment term, meaning that the borrower's monthly payments and repayment period can fluctuate.
2. How Funds Are Accessed
Another key difference between home equity loans and HELOCs is how funds are accessed. Home equity loans are typically disbursed as a lump sum, meaning the borrower receives the entire loan upfront. In contrast, HELOCs offer borrowers a revolving line of credit, allowing them to access funds up to a predetermined credit limit as needed.
3. Repayment Options
Repayment options are another aspect where home equity loans and HELOCs differ. Home equity loans necessitate fixed monthly payments throughout the loan's duration. HELOCs, however, offer more flexibility, allowing borrowers to make interest-only payments during the draw period and requiring principal and interest payments during the repayment period.
4. Fees and Closing Costs
Home equity loans and HELOCs also differ in their fees and closing costs. Home equity loans typically have higher fees and closing costs, including appraisal fees, origination fees, and closing costs. On the other hand, HELOCs may have lower fees and closing costs, making them a more affordable option for borrowers.
5. Risk of Foreclosure
Finally, home equity loans and HELOCs also differ in their risk of foreclosure. Since the borrower's home secures both types of loans, there is a risk of foreclosure if payments are not made. However, since HELOCs are revolving lines of credit, borrowers may be at a higher risk of defaulting on their loans if they continuously borrow against their credit limit.
Which Option Is Right for You?
When contemplating whether to apply for a home equity loan or a HELOC, several critical factors must be taken into account to make an informed decision. Some of the crucial factors that must be considered are:
1. Financial Situation
Do you have a good credit score, stable income, and sufficient equity in your home? If so, you may qualify for a home equity loan or a HELOC. However, if your credit score or income is not as strong, you may have more limited options.
2. Borrowing Needs
If you require a significant amount of funds upfront and prefer a fixed interest rate and payment term, a home equity loan could be the more suitable option. It is vital to assess how much money is needed and for what duration when determining which option is best. However, a HELOC may be more suitable if you need ongoing access to funds and prefer a flexible repayment term and interest rate.
3. Financial Goals
A home equity loan could be better if a borrower requires a one-time lump sum payment for a specific expense, such as a home renovation or debt consolidation. However, if the borrower has ongoing variable expenses, like college tuition or medical bills, a HELOC may offer more flexibility.
To decide which option is best, consider speaking with a financial advisor or a lender. They can help you evaluate your financial situation and borrowing needs and determine which option best fits your goals. Additionally, be sure to carefully read and compare the terms and fees of each loan option before making a decision.
Get the Most Out of Your Home’s Equity
Deciding between a home equity loan or HELOC is complex and requires a thoughtful assessment of one's finances. Each option presents distinct advantages and drawbacks, with the former offering fixed rates and lump sum payments while the latter provides more flexibility regarding borrowing funds.
Ultimately, individuals should consider their financial situation to make informed decisions that align with their goals—seeking expert advice from qualified advisors may benefit this process.
