HELOC Versus Home Equity Loan: What's the Difference?
If you've owned your home for a while, you've probably built up some equity in the property, which you may be able to borrow against to fund a variety of goals. A home equity loan and home equity line of credit, or HELOC, are two popular options. But which one is right for you?
Both options allow you to borrow against your home's equity at generally favorable interest rates. However, there are some key differences between a HELOC and a home equity loan. The right approach for you may depend on how you plan to use the money, along with a few other factors.
What is home equity?
Home equity is what your home is worth today, minus the outstanding mortgage or any other loan balances against it. For example, if the market value of your home is $600,000 and you owe $500,000 on a mortgage, your equity in the home is $100,000.
Generally speaking, your home's equity will grow over time as you make payments against the principal of your mortgage. However, as home prices fluctuate, your home equity may shift as well. For example, many homeowners have benefitted from rapid appreciation in today's housing market, which has increased the amount of equity they have built up in their home. Likewise, undertaking renovations to increase your home's value may also boost your home equity.
While not common, it's also possible for your equity to decrease. For example, a dramatic decline in home values could result in negative equity for some homeowners. Buying a home with a small down payment may increase the risk of this occurring.
Benefits of using home equity
One of the more significant benefits of tapping into your home equity is the low cost of borrowing. Because they use your home's value as collateral, both home equity loans and HELOCs may offer a lower interest rate than other borrowing options, like a personal loan or credit card. This makes them a popular option for funding home renovations and repairs. Some homeowners may also leverage their home's equity to fund other goals—such as consolidating higher-interest debt, paying for college or starting a business.
The ability to deduct the interest you pay is another potential benefit of both HELOCs and home equity loans. This deduction may reduce your taxable income, lowering the tax burden for any years when you've paid interest on the loan. To qualify for this deduction under the current tax law in effect through 2025, the funds must be used to buy, build or substantially improve your residence. As always, it's a good idea to speak with a tax specialist to ensure you meet the criteria before claiming this deduction.
How does a home equity loan work?
A home equity loan allows you to borrow a lump sum of money and repay it over a set period—usually anywhere from 5 to 15 years—making it an attractive option for those in need of significant funds to finance a big project, like a kitchen remodel. Your creditworthiness, your household income, the lender's policies and your home equity will determine how much you can borrow. Most home equity loans feature a fixed interest rate, which means your monthly payment should remain consistent.
While having predictable payments and access to a lump sum are two benefits of a home equity loan, there are a few other factors to consider. First, unlike the typical HELOC, you'll need to start repaying the principal balance on your home equity loan immediately. Also, home equity loans tend to have higher closing costs than HELOCs, so be sure to factor those expenses into your budget.
How does a HELOC work?
A home equity line of credit functions more like a credit card than a traditional loan. With a HELOC, your lender will approve you for a maximum credit limit. You can borrow up to this spending limit as needed, and you'll only need to repay the portion of the credit line you use. This may make HELOCs ideal for individuals looking to finance ongoing remodeling projects or pay for small home repairs as they arise.
There are a few nuances to consider, however. First, HELOCs usually come with a variable interest rate, so your monthly payments may change during your loan term. Also, lenders often charge an annual fee for keeping the line of credit open, even if you don't draw on it. And finally, a HELOC's repayment terms are different from most other types of loans.
How does HELOC repayment work?
A HELOC has two phases—the draw period and the repayment period. During the draw period, you may borrow funds as often as needed, up to your approved spending limit. Of course, you can pay down these balances quickly during this phase if desired. But depending on your borrowing agreement, you may be allowed to pay only the accrued interest or a small percentage of the principal balance. While this may help you free up cash for remodeling expenses, be aware that making smaller payments during the draw period will increase the amount you'll need to pay once you enter the repayment period.
Once the repayment period begins, you can no longer borrow money and must begin making full principal and interest payments. Some lenders may require you to pay off the remaining balance in full, which is known as a balloon payment. Others may convert your remaining balance into an installment loan. Be sure to ask your lender about your HELOC's repayment terms before you sign on the dotted line.
Home equity loan versus line of credit
While the two options share similar benefits, there are some critical differences between a HELOC and home equity loan that may impact which is the right fit for your goals. Ultimately, the right option for you may depend on your financial preferences and how you intend to use the money.
If you plan to use the funds for a defined project or expense, know exactly how much you need to borrow and like the idea of predictable monthly payments, a home equity loan may be your best option. However, if you plan to spend the money in smaller increments over time, are unsure how much cash you'll need and are comfortable with a potentially fluctuating monthly payment, a HELOC may be better suited to your needs.
Calculate your loan options as you weigh the pros and cons of a HELOC versus a home equity loan.
What are the disadvantages of using home equity?
While borrowing against your home's equity may offer several key benefits, there are a few potential risks to be aware of. First, it's important to know that your home will serve as collateral for both a HELOC and a home equity loan. If you fail to pay as agreed and default on either, your lender could potentially foreclose on your home to recoup any unpaid debt. You may also face a serious problem if your home's value suddenly decreases. If you're uncomfortable with these risks, you might want to explore unsecured financing options, like a credit card or personal loan, even though they tend to cost more.
Finally, if you don't have much equity built up in your home, a home equity loan or HELOC may not provide you with the amount of capital you need. If you're using the funds to make updates to your home, you may wish to explore other ways to finance home renovations, such as a home improvement loan.
Key takeaways
If you have questions, talk to a banker. They can walk you through both options and help determine which is best suited for your goals.
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