HELOC Vs. Home Equity Loan For a Down Payment: Which Is Best?

When you’re getting ready to buy a home — whether it’s for a primary residence or a rental property — it’s important to consider how you’ll come up with the down payment. If you already own a home (and have equity in it), two of your options are to get a home equity loan or a home equity line of credit (HELOC).

But before you jump in, it’s essential to understand the pros and cons of these loan options. This comprehensive guide explores the ins and outs associated with leveraging your home’s equity for a down payment, helping you make an informed decision for your financial future.

What are home equity loans and HELOCs?

Both types of loans are based on the amount of equity in your home. However, the way the funds are disbursed and how you pay them back have some key differences. With a home equity loan, you borrow a lump sum of money and it often comes with a fixed interest rate and equal monthly loan payments. That makes these types of loans easier to budget for and often come with better interest rates than other lending products.

By contrast, a HELOC is a revolving line of credit, similar to a credit card, where you can access funds as needed, up to your approved credit limit. It’s also important to note that HELOCs usually have variable interest rates, which can make your monthly payments less predictable. However, in most cases, HELOC payments during the draw period consist of interest-only payments, which can give borrowers more flexibility when repaying their line of credit.

In either scenario, borrowers need to be aware that either type of loan uses the primary residence as collateral. Essentially, if you can’t make your loan payments, you risk losing your house and all that equity you’ve worked so hard for, says Andy Heller, a real estate investor, author, and educator at RegularRiches.com

Can I use a HELOC or home equity loan for down payment money?

As long as you have enough equity in your home, and meet the lender’s other requirements, you can use those funds however you choose, including for a down payment. Borrowers seeking a new property can use the loan money as follows:

To purchase an investment property

If you plan to purchase a new home as an investment/rental property, you can tap into the equity of your current home to use it as a down payment. Different properties to consider include a single-family home, duplex, condo, or townhome.

A rental property is a great way to earn extra income. And using the equity from your primary residence allows you to leave other, more liquid, assets untouched, explains Rebecca Awram, mortgage advisor at Seniors Lending Centre.

To buy a vacation home or second home

You can also access the equity in your primary residence to purchase a second home or vacation property for your own use. In this case, because you won’t earn rental income, you’ll want to ensure you have enough money in reserves to cover the existing mortgage, plus the equity loan or HELOC payments, and the new mortgage.

If you lose your job or suffer another financial hardship, you still need to make your loan payments on time or risk losing your home and destroying your credit score.

Is a home equity loan or HELOC better for a down payment?

The decision on whether to use a HELOC or an equity loan depends on multiple factors. Issues to think about include how much money you need for the down payment, how long of a loan term you want, your income, and credit history.

Talking to loan lenders who specialize in equity lending or real estate experts can help you sort out which option is best for your financial situation. But there are a few basics HELOC and home equity loan borrowers should consider.

Home equity loan for down payment

As mentioned previously, with a home equity loan, you get a lump sum of money you can use for whatever you want, including a down payment on a house. A fixed interest rate and equal monthly payments also make it easy to budget for, which can make it more appealing to some borrowers.

Lenders vary, but some will allow borrowers to take out a home equity loan for up to 85% of their home’s value minus what they owe on the mortgage. For example, if your house is valued at $500,000 and your mortgage balance is $300,000, your equity is $200,000. Based on that equation, you could borrow up to $125,000 to put down on a new property — a sizable down payment.

Another issue to keep in mind is that this isn’t a quick loan process. Getting a home equity loan can be lengthy, and you will need to get an appraisal and pay additional fees. That means you’ll need to plan ahead if you want to use a home equity loan as your down payment option. Most lenders won’t approve a mortgage without proof that you have enough money to put down.

HELOC as down payment

A HELOC can be a better option for borrowers who need to make smaller down payments because, for instance, you may want access to that flexible line of credit down the road for other purposes, such as home improvements. Plus, since it’s a credit line, you may not be able to borrow as much as with a lump-sum loan in some.

For example, imagine you’re looking to buy a home for $200,000. A typical down payment for this type of purchase is 20%, or $40,000. If you had enough equity in your home to qualify for a HELOC with a $50,000 limit, you could borrow the full amount you need to cover the down payment and still have funds left over.

But again, like an equity loan, a HELOC isn’t the fastest option. Personal savings or borrowing from your retirement accounts can mean quicker access to funds. Another option is to apply for a personal loan instead, which has a much faster qualifying process. In addition, you won’t have to risk using your home as collateral.

Home equity alternatives

Home equity investments (also known as shared equity agreements) are another option if you are in the market for a home equity line of credit but either don’t meet the eligibility requirements or prefer an option that doesn’t involve additional debt. The main advantage of home equity investments is they offer access to your home equity without any interest or monthly payments. Instead, investors buy a share of the future appreciation of your home. You get a lump sum now and return the investment plus the agreed share in home appreciation when the term ends, or you sell the home.

FAQs

Are there any restrictions on how I can use the funds obtained through a home equity loan or HELOC for a down payment?

There are no restrictions on how you can use the funds obtained from a home equity loan or HELOC. Still, it’s not a good idea to use them for frivolous purposes. Aside from down payments, common uses for home equity funds include consolidating high-interest debt, making home improvements, or starting a business.

What factors determine the amount I can borrow through a home equity loan or HELOC?

The amount you can borrow depends on how much equity you have in your current home and the lender’s requirements. Typically, you can borrow up to 85% of your home’s value minus your outstanding mortgage balance.

How do I decide between a HELOC and a home equity loan for a down payment?

The choice between a HELOC and a home equity loan depends on your specific financial situation. HELOCs offer flexibility and variable interest rates, making them suitable for smaller down payments. Home equity loans provide fixed interest rates and predictable monthly payments and may be better for a larger down payment.

What are the risks associated with using a home equity loan or HELOC for a down payment?

The primary risk is that your home serves as collateral, and defaulting on the loan can lead to the loss of your home. Additionally, some loans come with high fees (such as closing costs and origination fees), and variable interest rates can cause your loan payments to fluctuate.