Home Equity Loan vs. HELOC: Pros and Cons
When talking about personal finance, mixing up a home equity loan with a home equity line of credit (HELOC) is one of the more common occurrences.
While these two forms of financing may sound extremely similar and relate to the same thing, they are quite different, and each has its own set of pros and cons.
Both home equity loans and HELOCs pertain to you, the homeowner, utilizing the equity in your home to borrow cash. If you owe a lot less on your mortgage relative to the current value of your home, you can use either a HELOC or home equity loan to take out a loan that is secured by your home.
Because you are using your home to guarantee the financing, home equity loans and lines of credit typically are easier to qualify for, in addition to having lower interest rates and generally favorable repayment terms.
And, it is important to always remember the fact that you are using your house as collateral for both a HELOC and home equity loan. This means that if you default on either financing option, you run the risk of losing your home to foreclosure.
Finding the equity in your home is quite simple; all you have to do is deduct what you still owe on your mortgage from the current market value of your home. That resulting figure is your home equity, which is then used as collateral on either a home equity loan or HELOC.
As noted above, HELOCs and home equity loans differ in a few regards, while each has its respective benefits and potential pitfalls.
Let’s go through both financing options, including the positives and negatives, so you get a better idea as to if a home equity loan or line of credit is the right product for you.
What is a Home Equity Loan?
A home equity loan, often referred to as a second mortgage, is a loan that allows you to borrow against the equity you have in your home.
Home equity loans come with a fixed interest rate and consistent monthly payments, which means you will have a set repayment term that will end with you having no more home equity loan debt. Home equity loans are provided to you in one lump sum.
Because of the security that comes with a fixed interest rate on a home equity loan, interest rates are generally higher for this form of financing compared to HELOCs of the same value. However, home equity loan interest is often times tax deductible if the funding is used to buy, build, or improve the home that the loan is being used for.
Due to the lump sum that you get with a home equity loan, this financing is most often used for large home renovations, like redoing a bathroom, but is also used to pay off high-interest credit card debt because of the low interest rate that is often provided.
Home Equity Loan Pros
- Low, fixed interest rate with easy-to-budget for, consistent monthly payments and a set repayment term.
- Interest on home equity loans may be tax deductible if used to buy, build, or improve your home.
- Comes in a lump sum, which can be used for anything, like paying off credit card debt.
Home Equity Loan Cons
- Utilizing all of the equity in your home at once can backfire if home values drop near you.
- If your credit score is not great, you may not receive the most favorable interest rate and loan terms.
What is a HELOC?
A home equity line of credit (HELOC) is similar to a home equity loan in that you are borrowing against the equity in your home, but rather than giving you the full loan amount in one lump sum, HELOCs work like credit cards as you will receive a line of credit that you can borrow as much or as little from.
Further, you will only pay interest on the amount of financing that you access from the HELOC. The interest rates on HELOCs are usually lower than those seen for home equity loans, but rather than a fixed rate, HELOC interest rates are variable. This means that your monthly payment can increase or decrease depending on how the interest rate behaves.
HELOCs will usually come with a draw period, which is when you are able to access the money granted to you via line of credit from your home’s equity. After the draw period, you will enter the repayment period, which is when you are no longer able to borrow and must repay what you accessed in financing.
Further, you are still required to make minimum monthly payments during the draw period.
Remember, you can borrow as much or as little as you would like from your HELOC, which makes this option great for homeowners that aren’t quite sure what they will use the financing for, but want the option nonetheless.
Pros of a HELOC
- You can borrow as much or as little as you want, depending on the equity you have acquired in your home.
- In this same vein, you will only need to pay interest on what you borrowed, not the total size of the line of credit.
- Possible to make minimum payments only during the draw period.
- Interest may be deducted if HELOC was used for home improvements.
Cons of a HELOC
- Variable interest rate that comes with a HELOC can lead to unpredictable payments that may be difficult to afford if rates rise.
- It is possible to overspend your line of credit, which will lead to large monthly payments due to interest charges.
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