A home’s equity is a key advantage of owning a home. However, you can only access it when you sell your home or take out a home equity loan or a home equity line of credit (HELOC).
Using either a loan or line of credit can be helpful if you need to access a sum of money with favorable rates or low fees. There are some key differences to consider when it comes to choosing which one is best for you. Take a look at our guide below to learn about the differences between both home equity loans and home equity lines of credit.
Home Equity Loan vs. Line of Credit
Here’s a quick definition of each option:
A home equity loan is a lump sum of cash that is repaid with fixed payments during a set period.
A home equity line of credit is a flexible loan that allows you to borrow and repay multiple times up to the maximum amount agreed on by the lender, similar to a credit card.
There are a handful of similarities between these options:
- Collateral: Your home is used as security for lenders in the event you cannot pay back the loan.
- Equity: Both options borrow against the value of the home that you actually own, known as your home’s equity. We’ll go into more detail about how to calculate this later.
- Second mortgage: These options are commonly referred to as second mortgages since you’re borrowing against the value of your home.
- Tax deductible: The IRS says that interest payments for either option are potentially tax deductible if the loan is used to improve or remodel your home.
Here are the key differences between both:
|Home Equity Loan||Home Equity Line of Credit|
|Funds||Borrow up to the
|Given a lump sum upfront|
|Interest||Typically a variable rate||Typically a fixed rate|
|Payments||Only make payments based on the amount borrowed||Fixed payments during
a set time
Calculating Your Home’s Equity
You can determine your home’s equity by subtracting the amount you currently owe on your mortgage from the value of your house.
Another number you’ll need to know is your combined loan-to-value (CLTV) ratio. This is a percentage found by dividing the total amount you owe on all home loans by your home’s market value. The lower your CLTV, the lower your credit risk and higher your chances are for receiving the loan.
The amount you’re able to borrow against your equity greatly varies between lenders. For example, Discover offers loans up to 95 percent of your combined loan-to-value ratio. On the other hand, some lenders put a cap on the total amount you can borrow. U.S. Bank, for example, allows customers to borrow $750,000 and up to $1 million for California properties.
You can sometimes borrow more in exchange for higher costs and/or interest rates.
Let’s assume that you meet a lender’s income level, credit score and other requirements for a second mortgage. For this example, let’s also assume the following:
- Home loan debt: $200,000
- Home’s worth: $600,000
- CLTV ratio (home loan debt divided by home’s worth): 33 percent
- Lender allows a CLTV of 90 percent
With these numbers, we can find the maximum debt amount and the amount you can borrow. The maximum debt amount is the total amount a lender would loan you based on your home’s value. The amount you can borrow is the sum they will lend based on what you currently owe.
- Maximum debt amount (multiply home’s worth by 90 percent): $540,000
- Amount you can borrow (maximum debt amount minus current home loan debt): $340,000
Keep in mind that lenders can foreclose your home if you default on the loan since you’re using your home as collateral. Make sure the amount you borrow is a total you’re confident you can repay.
Home Equity Loans Pros and Cons
Home equity loans are a consistent option that can make it easier to predict your monthly budget. They’re also great if you need funds upfront for a large expense. However, you can end up paying a lot, especially in the beginning, since you are paying interest on the entirety of the loan.
The biggest benefit of a home equity loan is its predictability. Below are a few other benefits to using home equity loans.
- In some instances, a fixed interest rate
- Fixed monthly payments
- Set payment period
- It’s an amortizing loan, meaning that payments reduce the loan balance and cover some interest costs
Home equity loans fall short in their inflexibility and potentially high long-term costs. Here are a few other drawbacks to consider.
- High interest costs in the beginning since you’re borrowing a large sum
- May pay more than your home is worth if your home’s value goes down over time
When You May Use a Home Equity Loan
A home equity loan may be a good option for those who have large one-time expenses like a home renovation project.
Some also use a home equity loan to wipe out a large amount of debt since it’s sometimes more affordable to get a large lump sum like this using a home equity loan compared to other loans. However, its affordability in comparison to other options is heavily reliant on an individual’s financial situation.
This option is also great for borrowers who prefer consistent terms and want a predictable payment plan.
HELOC Pros and Cons
HELOC’s are flexible options that allow you to borrow only what you need when you need it instead of dispersing the entire amount, similar to a credit card. This way, you only pay interest on what you borrow, but have variable interest rates as a result.
A major difference to note between home equity loans and HELOC’s is that HELOC’s typically have a “draw period” and a “repayment period.”
- The draw period is the time a borrower can access the funds. They’re able to continually borrow and repay during this time, up to the maximum allowed amount. During the draw period, borrowers are required to pay at least the monthly minimum payment.
- The repayment period immediately follows the draw period. This is the time borrowers are required to pay back the outstanding balance.
HELOC’s are great for those who want more flexible payment options. There are a few other benefits to consider with this option.
- Borrow only what you need
- Pay interest only on what you borrow
- Some offer a fixed-rate loan option that allows borrowers to convert variable-rate HELOC balances into a fixed-rate option
- Some offer options to delay the repayment period
- Some offer interest-only periods that allow borrowers to pay only interest for a fixed time
- Borrowers can keep interest costs low if they carry a small or zero balance
Variability with HELOC’s comes at a price—you may end up paying higher interest rates depending on when and how much you borrow. Get familiar with other HELOC drawbacks.
- Interest rates can fluctuate based on the market and result in higher interest debt
- Flexible borrowing may entice some to overspend
- May need to meet minimum withdrawal amounts and other requirements to borrow
- Lenders can lower or close your HELOC
When You May Use a HELOC
This option may be more appealing for those with expenses that occur in stages. For example, you may have a long-term home improvement project, but are unsure how much each phase of the project will cost.
It’s also an option for things like college tuition when you don’t know how much aid you’ll receive from other financial sources. With HELOC’s, you have the flexibility to only borrow what you need.
HELOCs are also great for borrowers who don’t want to be locked in to a long payment plan and don’t want to initially borrow more than what they might need.
Other Factors to Think About
Do your research when comparing these offerings with each other and other options to ensure you’re making an informed decision. Here are just a few things to consider:
- Interest rates: Although second mortgages generally offer more favorable rates than other loans, the amount lenders offer can vary. This variability increases if you choose a HELOC.
- Fees and penalties: Expenses like closing costs and appraisals can drive up the initial cost of taking out either option.
- Foreclosure risks: Both options put you at risk of losing your home if you’re unable to pay back what you borrow.
- Owe more than your home’s worth: You may end up paying a lot more than what your home’s actually worth, depending on market fluctuations and the loan type. Home equity loans may result in higher interest debt since your rate is locked in from the beginning. If you need to sell your house while you’re using either second mortgage option, you may end up owing more than your home’s worth or end up upside-down on your loan.
You should also consider other types of loans and financing options depending on your needs and financial standing. Work with a trusted mortgage provider or financial provider to help guide you through your decision.
If you find that your credit score is holding you back from the options you want, you can take a look at these tips for securing a loan with bad credit. If you were in the market for a loan because you’re having trouble keeping up with payments, you can also consider refinancing your mortgage.
Refinancing a mortgage with bad credit is possible, it’s just a bit more complicated than refinancing with good credit. When you’re shopping around for any loan, make sure to read the fine print, do your research and explore all of your options before making a decision.