HELOC vs. home equity loan: understand the difference

Find out which one is better for your finances

HELOC vs. home equity loan: do you know the difference? If not, we can help! Home equity loans and home equity lines of credit (HELOCs) are different borrowing options with distinct advantages and disadvantages, including interest rates, fees, repayment terms, and eligibility requirements. Know more!

The moment of buying or renting a house is remarkable in people's lives. In this regard, you may need a loan. However, HELOC vs. home equity loans is some of the main ones.

However, each type of financing is ideal for a specific need. You must know which system they work in to select the best option. Keep reading!

What is the difference between a HELOC and a home equity loan?

HELOC vs. home equity loan: With a HELOC, you're approved for a certain amount of credit, but don't borrow all the funds upfront. Instead, you have a 10-year "draw period" in which you can borrow money as you need.

Therefore, HELOCs typically have adjustable interest rates during the draw period. Home equity loans are structured differently.

With a home equity loan, you borrow a lump sum of cash and immediately begin making fixed payments at a set interest rate. Home equity loans have shorter repayment periods than HELOCs and usually have fixed interest rates.

Because home equity loans are a one-time disbursement, they may be the better choice if you need certainty about your monthly payments. Or want to avoid the temptation to borrow more money than you can afford to repay.

HELOC: how does it work?

A home equity line of credit (HELOC) is a home equity loan that works like a credit card. You are approved for a certain amount and can borrow against that amount as needed, up to the limit.

You only pay interest on the amount you borrow; the interest rate is typically lower than on a credit card. A HELOC typically has a set term (10 years, for example), and then you must begin making monthly payments to pay back the loan (20 years, for example).

Because your home secures a HELOC, your lender could foreclose on your home if you default on the loan. That's why making sure you can afford the monthly payments before taking out a HELOC is important.

Check out more about the pros, cons, and requirements of HELOC.

Pros

Get approved for a loan without leaving your home;
Access funds repeatedly without reapplying;
Borrow exactly what you need when you need it;
Only pay back that amount, plus interest;
Deduct interest on qualified HELOCs used for home renovations;
Offer flexibility with the payoff, including converting a portion of your balance to a fixed rate.

Cons

Steady monthly payment;
Fixed interest rate and no annual fee;
Flexibility to use credit line for whatever you need;
Option to pay off your HELOC at any time without penalty.

Requirements

Home equity is important to have before applying for a HELOC;
The total amount you can borrow depends on the amount of equity you've built over time;
Lenders will review your total income and the amount of debt you're already balancing;
Your credit history will also play an important role in the approval process.

Home equity loan: how does it work?

Home equity is the portion of your home's value that you own outright. It's the market value of your property minus any outstanding loans, such as your mortgage.

Most homeowners gain equity by making a down payment when they purchase their home. Your equity will then fluctuate over time as you make monthly mortgage payments and your home's market value changes.

Some things that can impact your home equity loan are renovations or repairs to your home or changes in property values in your community.

Check out more about the pros, cons, and requirements of a Home Equity Loan.

Pros

A fixed interest rate that will not change;
Monthly payments that stay the same for a set period;
Access to larger funds than you may get with other types of loans;
Often comes with a lower interest rate than other loans due to your home being used as collateral;
It can be used for anything, from financing a car to vacation.

Cons

You can use the equity in your home to get a lower interest rate than with other types of loans;
The approval process is fast, and you can get the money in as few as 7 days;
You can borrow up to 85% of your home's value minus what you still owe on your first mortgage;
There are no prepayment penalties, so you can pay off your loan at any time without penalty.

Requirements

You need to have a certain amount of equity established in your home before you can use it to secure a loan.
To qualify, most lenders require that you have already paid off at least 15% to 20% of your home's total value.
The lender appraises your home's market value as part of the application process, which typically comes at your expense.
Your debt-to-income (DTI) ratio may also help determine your qualifications. Your DTI ratio is calculated by dividing your total monthly debt payments by your gross monthly income. While qualifying DTIs vary depending on the lender, the general rule of thumb is that your debt should be less than 43% of your total monthly income.

Which one should you choose: HELOC vs. home equity loan?

Choosing the right home equity financing depends entirely on your unique situation. Typically, HELOCs will have lower interest rates and greater payment flexibility, but a home equity loan is better if you need all the money at once.

If you are trying to decide, think about the purpose of the financing. Are you borrowing to have funds available as spending needs arise over time, or do you need a lump sum now to pay for something like a kitchen renovation?

A home equity loan offers borrowers a lump sum with an interest rate that is fixed but tends to be higher. HELOCs, on the other hand, offer access to cash on an as-needed basis but often come with an interest rate that can fluctuate.

Ultimately, the best option for you will depend on your specific financial situation.