Whether you’re trying to consolidate high-interest credit card debt, finance a home improvement project, or borrow for any other reason, home equity loans and lines of credit can be a great way to borrow at a low interest rate. But which is best? This home equity loan vs. line of credit review guide will help you decide which is best for you.
Both options use the equity you have in your home as collateral, so you can get a better interest rate than if you were to use a personal loan. As such, it’s important to use one of these products only if you know for sure that you can make the payments. Otherwise, the lender might repossess your house.
So, what’s the difference between a home equity loan (HEL) and a home equity line of credit (HELOC)? Which option is better? Let’s find out right now.
What is a home equity loan?
With a HEL, you can borrow a fixed amount of money using your home equity as collateral.
“All the money is advanced upfront, you cannot draw any more, and you must pay it off in fully amortized payments,” says Casey Fleming, mortgage advisor and author of “The Loan Guide: How to Get the Best Possible Mortgage.”
There is a draw period — usually 10 years — during which the minimum payment is interest-only. But you can pay down whatever you wish and draw as much as you wish as long as there is room on the line.”
The amount you qualify for depends on how much equity is in your home, your payment term, income, and credit history. These loans come with a low fixed interest rate, and you typically repay it over a period such as 15 or 30 years.
The greatest risk in an equity line is that most homeowners never pay it down. When the draw period is over, their payment suddenly jumps, and if interest rates are rising, that jump is exacerbated”
A HELOC is sometimes called a second mortgage.
Compare the pros and cons to make a better decision.
- Fixed interest rate: With a variable rate, your interest rate can change as market rates fluctuate. This isn’t a bad thing if market rates are trending downward. But as of August 2017, market rates are trending upward, making a variable rate less beneficial.
- Predictable payments: With a fixed interest rate and a fixed repayment period, you don’t have to worry about payments becoming unaffordable in the future.
- Costs and fees: As with a normal mortgage loan, HELs come with closing costs, which can be anywhere between 2% and 5% of the loan amount. Some even have ongoing maintenance fees. Depending on your loan terms, fees could eliminate the benefit of the lower interest rate. “Generally, equity loans will have a little more in fees [than a line of credit] to put in place,” says Fleming.
- You could lose your house: With your house’s equity as your collateral, the lender can repossess your house if you fail to pay off the loan. Make certain that you can keep up with the payments throughout the life of the loan.
Click here to discover home equity loans vs. personal loans and credit cards.
What is a home equity line of credit?
With a HELOC, you get a revolving credit line that gives you access to money when you need it.
Like a credit card, you can borrow some cash, pay off the loan, then borrow again. The credit line is typically a percentage of your home’s equity, and the lender will also consider your other debt payments, income, and credit history.
With a HELOC, your interest rate is typically variable. You can’t just draw money from your HELOC whenever you want, though.
“There is a draw period — usually 10 years — during which the minimum payment is interest-only,” says Fleming. “But you can pay down whatever you wish and draw as much as you wish as long as there is room on the line.”
Once that’s over, the lender might require that you pay it back all at once, or over a set repayment period. At the end of the draw period, you can also request to renew the HELOC, if your lender allows it.
Home equity line of credit advantages and disadvantage
Costs and fees: As with a normal mortgage loan, HELs come with closing costs, which can be anywhere between 2% and 5% of the loan amount. Some even have ongoing maintenance fees. Depending on your loan terms, fees could eliminate the benefit of the lower interest rate. “Generally, equity loans will have a little more in fees [than a line of credit] to put in place,” says Fleming.
You could lose your house: With your house’s equity as your collateral, the lender can repossess your house if you fail to pay off the loan. Make certain that you can keep up with the payments throughout the life of the loan.
Compare the pros and cons to make a better decision.
- Pay interest only on the amount you use: Although your line of credit might be worth a large percentage of your equity, you only pay interest on the amount you borrow using the line of credit.
- Might offer interest-only payments: If you’re still in the draw period, your lender might allow you to make interest-only payments to give you some more flexibility.
- Variable interest rate: HELOCs aren’t known for their stability regarding the interest rate. If market rates increase in the future, so will your interest rate, causing an increase in your monthly payment. If you’re not sure you can afford higher payments, steer clear of a HELOC.
- Makes it easier to get into debt: Because you can draw on your credit line whenever you want, like a credit card, it could tempt you to spend more than you need. With a HEL, however, your loan terms are fixed so you can’t go back and borrow more without taking out another loan.
Click here to discover personal loans vs. lines of credit.
Which is better: a home equity loan or line of credit?
As with any financial decision, it depends on your situation and needs.
If it’s a one-time need or you’re not sure you can manage higher payments in the future, go with a HEL. If, however, you might need to borrow on an ongoing basis and you’re fine with payment flexibility, a HELOC would be a better choice.
Here’s a quick summary of the differences to consider as you’re deciding whether to use a HEL or HELOC:
HELOC vs. home equity loan– which should you choose? Well, before you make that decision, think twice about getting either.
“The greatest risk in an equity line is that most homeowners never pay it down,” says Fleming. “When the draw period is over, their payment suddenly jumps, and if interest rates are rising, that jump is exacerbated.”
And remember that you could lose your home if things don’t go as planned. So, make sure your reason for borrowing is worth that risk.
Once you’ve decided that it is, be sure to compare several mortgage lenders to get the best rate.
Each has its own underwriting criteria. So, while one might not give you favorable terms, that doesn’t mean none of them will. The more time you spend shopping around, the more likely you’ll be to get the best terms possible.
Ben Luthi is a personal finance writer and a credit cards expert who loves helping consumers and business owners make better financial decisions. His work has been featured in Time, MarketWatch, Yahoo! Finance, U.S. News & World Report, CNBC, Success Magazine, USA Today, The Huffington Post and many more.