HELOC vs. home equity loan: Pros and cons

Overview: HELOC vs. home equity loan

The biggest difference between a home equity loan and a line of credit is the way you receive the funds.

A home equity loan provides the money upfront, all at once; with a HELOC, you have the option of taking funds over time.

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How does a home equity loan work?

A home equity loan is a "second mortgage" that you take out in addition to your primary home loan. It allows you to borrow against your equity in one big chunk, with a fixed interest rate.

After the loan closing, the lender either cuts a check for the lump sum or wires funds to your bank account. You then repay the loan over time, often 10 to 30 years, in equal monthly installments. It’s a good option for homeowners who prefer predictable payments.

To figure out how much you can borrow, start by calculating your home equity by finding the fair market value of your house and subtracting your mortgage balance. If your home is worth $300,000 and your first mortgage balance is $200,000, that means you have $100,000 in equity.

But you can't necessarily borrow the entire $100,000 — it depends on the lender and loan program. While some home equity loans allow you to borrow up to the full 100% of your available equity, lenders usually limit you to around 85%, says the Federal Trade Commission.

More: How much equity do I have in my house?

As with any financial product, there are benefits and drawbacks to a home equity loan. Carefully consider these before moving forward.

Pros of a home equity loan

• Interest rates are fixed. That means your payments won’t change over the life of the loan, and the predictable payments can help you budget.
• Interest rates are lower vs. other loans. Because your home is used as collateral, home equity loans have lower interest rates compared to their unsecured counterparts.
• You can use the funds for anything. Lenders generally don’t pose restrictions on what you do with the money.
• The interest may be tax-deductible. If you use the loan to "substantially improve" your home, the IRS allows you to deduct the interest payments on your taxes.

Cons of a home equity loan

• Your house secures the loan. If you fall behind on payments, the lender can take your home. You’ll have to consider whether you’re willing to accept that risk.
• Interest rates may be higher than for a HELOC. Because your interest rate is fixed, home equity loans typically come with higher interest rates compared to home equity lines of credit (which have variable rates).
• You’ll have to pay closing costs. Like a first mortgage or a refinance, home equity loans come with closing costs. These are usually equal to 2% to 5% of the loan amount, and you may choose to roll the costs into your loan amount.
• You’ll have two mortgage payments. If you’re still repaying your first mortgage, then you'll have two mortgage payments that will take up more of your disposable income. That will slow your other financial goals.
• You need home equity to qualify. It could take decades for you to build up enough equity in your home before you can borrow a sizable amount.
• You might make your debt more risky. When taking out a home equity loan for debt consolidation, you might end up converting unsecured debt (like credit card debt) into secured debt (secured by your house — and putting it on the line). It might be a better idea to look into an unsecured personal loan to consolidate your debt at a lower interest rate.

What is a HELOC?

A home equity line of credit, or HELOC, is a revolving credit line that usually comes with a variable interest rate. The lender approves you for a specific amount of money — the line of credit — that you can borrow from on demand.

Most HELOCs allow you to borrow from the account during a draw period," around 10 years, using checks or a credit card tied to the account. Once you hit your credit limit, you can pay down the line and borrow from it again. As with a credit card, you pay interest only on the money you're using.

At the end of the draw period you enter the "repayment period," typically 15 to 20 years. Because the interest rate is variable — meaning it can increase or decrease — your payments may fluctuate. Lenders use a benchmark interest rate, such as the prime rate, to determine how to raise or lower the rate on a HELOC.

Before signing for the HELOC, ask which index your lender uses and how often the rate can change. You might find you'll have an opportunity later to convert a portion of what you owe on the HELOC to a fixed-rate balance.

Depending on your creditworthiness and other factors, you may be able to borrow up to 85% of the value of your home, minus your mortgage balance. In other words, if you have $100,000 in home equity, you could potentially borrow as much as $85,000.

A home equity line of credit can provide a flexible way to borrow money, but payments can change. Here's a fuller look at HELOC pros and cons.

Pros of a HELOC

• You borrow only what you need. You might not know upfront how much money you want to borrow. A HELOC allows you to withdraw what you need, when you need it.
• Some HELOCs come without fees. Some lenders waive closing costs and fees, though you might need to meet eligibility requirements.
• The interest payments may be tax-deductible. Similar to a home equity loan, you can deduct interest payments if you use the money to make improvements to your home.
• You can use the funds for anything. Lenders generally don’t pose restrictions on how you use the money.

Cons of a HELOC

• You put up your house as collateral. As with home equity loans, you’re putting your home at risk because the house secures the line of credit.
• The payments are unpredictable. Because your interest rate is variable, it could increase anytime — and so will your payments.
• HELOCs can be costly. Depending on the lender, borrowers may pay annual fees, transaction fees on each withdrawal and closing costs. Some even come with a balloon payment, where you make one large payment toward the end.
• You'll also need enough equity to qualify. Same as for a home equity loan.
• You’ll find yourself juggling two mortgage payments. Also similar to a home equity loan.

More: How to slash the cost of your mortgage refinance

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How to choose between a home equity loan and HELOC

Whether you need money to pay down high-interest debt, start a business or take on any other project, home equity loans and lines of credit can be solid options.

If you’re thinking about borrowing from your equity, the first step is deciding between the two types of loans. Both offer potential tax benefits — plus, you can use the money for just about anything.

A home equity loan is a good option if you know exactly how much you need and want a predictable monthly payment. Some borrowers use these loans for debt consolidation, because you lock in one low interest rate and make predictable payments over time to eliminate the debt.

A HELOC is a good option if you’re not sure if and when you’ll need to borrow money. Some people use a home equity line of credit as an emergency fund or for long-term projects, such as a home repair or renovation.

More: Survey: Home renovation regrets and costs

How to get approved for a home equity loan or HELOC

Before you head to a lender, you can get a feel for whether you would qualify for either a home equity loan or a HELOC.

First, check your “loan to value” ratio, which helps lenders understand the risk they’re taking on. You do this by dividing your mortgage balance by the home’s fair market value. So if your home is worth $300,000 and you owe $200,000 on your mortgage, your LTV ratio is:

• $200,000 divided by $300,000 equals 0.67, or 67%.

Lenders typically approve loans with a loan-to-value ratio of around 80% or less. Since your LTV falls within that range, move on to the next step: calculating your home equity.

Subtract your mortgage balance from the home’s value to find your equity:

• $300,000 minus $200,000 equals $100,000.

Depending on your creditworthiness and other factors, lenders typically allow you to borrow up to 85% of your available equity. In this example, here's the maximum you might borrow:

• $100,000 times 0.85 (85%) equals $85,000.

The lender also will check your credit scores and your debt-to-income ratio, which measures how much of your monthly gross (pretax) income goes toward debt payments. To qualify, borrowers typically need a credit score of at least 620 and a DTI ratio around 43% or less.

If you're not sure about your credit score, you can check it for free. And if you find it needs work, you can improve it by paying down some debt and making on-time payments for all your bills.

Once you’re ready to apply for a home equity loan or line of credit, get quotes from several lenders. Shopping around can help you get the best HELOC rate and potentially save on fees.