HELOC vs home equity loan: How to choose the right one

HELOC or home equity loan?

Plenty of Americans are richer in home equity than they were a year ago thanks to rising home values across the nation. A HELOC or home equity loan can be a great way to cash out that equity.

Home equity lines of credit (HELOCs) and home equity loans are both second mortgages, meaning they let you tap your home’s cash value without refinancing.

But they have differences, too, including interest rates and closing costs. So take the time to explore HELOCs vs. home equity loans and see which is right for you.

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What is a second mortgage?

Also referred to as a ‘second mortgage,’ a home equity loan or home equity line of credit (HELOC) lets you access your home’s cash value without selling the home or refinancing your existing mortgage loan.

With either a HELOC or a home equity loan, you’re taking out an additional mortgage on top of your existing home loan (assuming you haven’t yet paid the original loan off). This will result in two separate monthly mortgage payments: one on your primary mortgage and one on your second mortgage.

When you apply for a second mortgage, your current equity determines how much you can borrow.

As a refresher, home equity is the value of your home minus what you owe on your mortgage. If you own a $300,000 home and owe $200,000 on your mortgage, you have $100,000 in equity.

HELOC vs. home equity loan

When you’re ready to borrow against your home’s equity, you will likely have three choices:

1. A fixed-rate home equity loan
2. A variable-rate home equity line of credit (HELOC)
3. A cash-out refinance loan

Let’s look at how these options compare.

Fixed-rate home equity loan

Simply put, a home equity loan is another mortgage loan that’s usually smaller than your current mortgage. You’d receive the total amount you intend to borrow in one lump sum and pay it back every month.

The repayment schedule for a home equity loan is typically 5-15 years. Since it’s an installment loan, the payment and interest rate remain the same over the lifetime of the loan.

Also, a home equity loan must be repaid in full if the home is sold.

Adjustable-rate home equity line of credit (HELOC)

A HELOC uses your home equity to fund a credit line which you can draw from as needed.

During the draw period you can use your HELOC like you’d use a credit card, but without the high-interest debt to worry about. Also during the draw period, you can choose to repay loan principal or only make interest payments each month, depending on your financial situation at the time.

The draw period (typically 5 to 10 years) is followed by a repayment period of 10 to 20 years, during which you can no longer withdraw funds and must repay any outstanding balance in full with interest.

Cash-out refinance

Unlike a home equity loan or HELOC, a cash-out refinance replaces your existing mortgage with a whole new loan.

The new loan balance is larger than what you currently owe, and the difference is paid to you at closing (minus closing costs).

Since a cash-out refinance is a first mortgage (not a second mortgage), it will typically offer lower interest rates than a HELOC or home equity loan. And requirements can be more lenient, too. FHA cash-out loans are even available with a credit score as low as 600.

On the downside, a cash-out refinance starts your loan over, so it may increase your total interest cost over the life of the loan.

The long-term cost depends on how much time is left on your existing mortgage and how low your new interest rate is compared to your old one.

Pros and cons of HELOCs vs. home equity loans

As you decide between a HELOC and a home equity loan, consider the pros and cons of both types of borrowing.

Home equity loan pros:

• Fixed interest rate and fixed payments
• Simplicity of an installment loan
• Single disbursement is ideal for big projects, purchases, or debt consolidation

Home equity loan cons:

• Less flexibility than a home equity line of credit (HELOC)
• Interest is charged on full loan amount, no matter how much of it you use
• Lenders may require higher credit scores than for traditional mortgages
• Not all lenders offer these loans
• Closing costs can be higher than for HELOCs

HELOC pros:

• Interest charged only on the amount drawn from the line of credit
• Can be paid off and re-used throughout the draw period
• Ideal for ongoing or not-yet-planned projects
• Some lenders charge no closing costs

HELOC cons:

• Variable interest rates make repayment less predictable
• Variable interest rate can increase your total cost if the prime rate rises
• Line of credit ties up equity even when you haven’t drawn from it

Which second mortgage loan is best for you?

So what’s your best option: a home equity loan or a HELOC? Jed Mayk, attorney and partner with Hudson Cook, LLP says that depends on your needs.

“A home equity loan might make more sense for a borrower who needs a set amount of money for a specific purpose,” he says. “This can include a home improvement project.”

A home equity loan also tends to be a better fit for needs such as:

• Debt consolidation
• Extensive home renovation requiring a large upfront payment
• Investing in real estate

But a home equity loan may not be the best choice “if you are unsure of the exact amount you may need now or in the future,” says Johnna Camarillo with Navy Federal Credit Union.

A HELOC might make more sense for those who need to borrow different amounts over a period of time, says Mayk.

Examples of good uses for HELOCs include:

• Regular tuition payments
• Extended “pay as you go” home improvements
• Providing emergency cash flow for a new business

HELOCs are best for those who don’t need instant access to their home’s equity.

“A HELOC can be used like a credit card. It’s great to have as a rainy day fund if your home needs emergency repairs,” Camarillo says.

Mayk says HELOCs are also popular with folks who have irregular income patterns. “This includes those paid a base salary and quarterly commissions.”

Other HELOC and home equity loan considerations

You need a good credit score to take advantage of either a HELOC or a home equity loan.

“A score of 620 or lower will make it hard to secure a [home equity] loan or HELOC,” says Theresa Williams-Barrett of Affinity Federal Credit Union. “Higher scores may provide access to higher loan amounts and lower costs.”

You also need to be confident in your earnings and job security. “Establishing a secure, constant source of income is very important,” Williams-Barrett says.

In addition, note that interest paid on home equity loans and HELOCs may or may not be tax-deductible. Check with a tax professional.

How home equity loans work

Like your current mortgage, a home equity loan would be an installment loan with a fixed interest rate that pays out a lump sum upfront. You’d make monthly payments, based on a repayment schedule, to pay off the loan.

But unlike your current mortgage — the one you used to buy the home — you could spend the funds from a home equity loan in any way you like.

You could even use the money for expenses not related to your home. For example, borrowers often use home equity loans to finance major expenses such as:

• Debt consolidation
• Medical bills
• College education
• A second home
• Home repairs
• Home improvement projects

A home equity loan is a versatile financial product, but it’s important to remember you can’t use the same equity over and over. These are secured loans, meaning you’re tying up your equity as collateral.

When you get a home equity loan, a “lien” is created against your house and reduces your actual home equity. If you sold the home before paying off the home equity loan, you’d have to repay both your primary lender and your home equity lender.

A lien also gives your lender the right to foreclose on your home if you can’t repay the loan as agreed. So, as with any mortgage loan, there are risks involved.

How HELOCs work

Like a home equity loan, a home equity line of credit (HELOC) taps your home’s existing value to generate cash you can use for any purpose you’d like.

But compared to a home equity loan, a HELOC has a few key differences:

• A HELOC is a credit line which you can draw from and then pay back repeatedly, much like you would a credit card. Since your home’s equity backs the credit line, you’d pay significantly less in interest compared to a credit card
• HELOCs typically have variable interest rates tied to the prime rate, so payments won’t be as predictable as a home equity loan’s fixed payments. HELOC payments are also based on the amount of the credit line you have in use each month
• There are few, if any, closing costs for HELOCs. The lender often covers the origination fee

HELOCs can extend credit as you need it, so they provide ideal financing for ongoing projects. Often, borrowers can move money from their HELOC into a checking account within minutes.

But a HELOC won’t last indefinitely. At some point — usually after 5 or 10 years — your HELOC’s draw period will end and you’ll have to follow a repayment schedule.

Some HELOC borrowers convert their lines of credit to home equity loans when they’re finished drawing from the credit line.

How much can I borrow with a home equity loan or HELOC?

Not all lenders offer home equity loans or HELOCs. And the ones that do typically limit the amount you can borrow to only a portion of your home’s equity.

Let’s look again at a $300,000 home with a $200,000 mortgage. The owner of this home would have $100,000 in home equity.

But odds are, the homeowner could borrow only about $55,000 of that equity through a second mortgage.

Why such a small amount? Because mortgage lenders enforce loan-to-value requirements, which limit the amount of your home’s value that can be tied up in mortgages.

Calculating your maximum home equity loan amount

Loan-to-value (LTV) calculations can be confusing because they apply to both mortgage loans — your existing mortgage as well as the new home equity loan or HELOC.

For example, an 85% loan-to-value maximum on a $300,000 home means the homeowner can hold only $255,000 worth of mortgages ($300,000 x 0.85 = $255,000).

Since the primary mortgage has a $200,000 loan balance, that leaves only $55,000 for the second mortgage.

Here’s a simple breakdown of this math from start to finish:

• Home’s appraised value: $300,000
• Mortgage loan balance: $200,000
• Equity in your home: $100,000
• Calculate 85% of your home’s current value: $300,000 x 0.85 = $255,000
• Subtract the $200,000 that you currently owe
• Total equity available to borrow: $55,000

Not all homeowners will be able to borrow the maximum amount of equity available, either.

Other factors that affect your borrowing power

Lenders also look at factors like your credit score, credit report, and debt-to-income ratio to determine how large of a loan you qualify for — just like they did when you bought your home.

In addition, the example above assumes you’ll have only two liens: the primary mortgage and the new home equity loan or HELOC. A third lien would limit borrowing power even more.

Because of these limits, you’ll probably need to build up a good amount of equity in your home before you’re able to borrow a large amount of money.

Fortunately, increasing home values have sped up the process of accumulating equity for many homeowners over the past year.

Additional ways to borrow from home equity

HELOCs and home equity loans (sometimes called HELOANS) aren’t the only ways to borrow against the value of your home.

Cash-out refinance

Rather than taking out a second mortgage, a cash-out refinance replaces your existing home loan with a new, larger mortgage.

The new loan is used to pay off your current mortgage, and the ‘extra’ amount is cashed out to you at closing.

Most mortgage lenders cap the amount you can borrow on a cash-out refinance at 80% of your home’s value. (The exception is VA cash-out refinancing, which allows a 100% loan-to-value ratio.)

Back to our example of a $300,000 home with $200,000 still due on the mortgage:

• Home value: $300,000
• Maximum refinance loan amount: $240,000 (0.8 x 300,000)
• Subtract existing mortgage balance: $240,000 – $200,000
• Maximum cash-out: $40,000 (minus closing costs)

Cash-out refinancing has some distinct benefits. It gives you one mortgage payment instead of two; interest rates are typically lower than for home equity loans or HELOCs; and if you’re paying a higher interest rate on your existing mortgage, you could save a lot by locking in a lower rate or a shorter term.

“This is an attractive option if doing so lowers your interest rate,” Camarillo suggests.

But keep in mind that refinancing starts your loan over at day one. If you’re almost done paying off your current mortgage, a home equity loan or HELOC might make more sense.

Convertible HELOC

Convertible HELOCs come with an additional feature — the conversion option.

At some point during the loan’s lifetime, you could convert your variable-rate HELOC to a fixed-rate home equity loan.

Your HELOC may already have a conversion option; some even give you more than one chance to convert during the life of the loan.

Keep in mind this may not be a great deal. The fixed-rate repayment period after the conversion may be longer, stretching out interest payments over a longer period of time. Also, at times, a variable interest rate is preferred to a fixed rate. And a convertible HELOC may charge higher fees.

Still, this is an option worth considering if you’d like a hybrid between a variable-rate HELOC and a fixed-rate HELOAN.

When shopping for a HELOC with a conversion option, ask lenders these questions:

• Is there a charge for the conversion? If so, how much is it?
• Will I be able to use the remaining credit available on the line after a conversion?
• Does the loan convert to a new fixed loan (for example, with a 30-year term), or is the balance amortized over the remaining term of the existing loan?
• How many times can I convert?
• How often can I convert?
• What determines the new fixed interest rate?

As always, make sure you fully understand the terms of the loan and the total long-term cost before signing on.

HELOC vs. home equity loan FAQ

Should you consider a home equity loan?

With home values on the rise, many homeowners have gained a lot of equity in their existing homes over the past few years.

Home equity loans and HELOCs can be affordable ways to unlock this equity without replacing your existing mortgage. Compared to other forms of borrowing, such as high-interest credit cards or unsecured personal loans, these loans can provide attractive interest rates.

But you’re putting your home on the line to get these low rates. You owe it to yourself to use this borrowing power thoughtfully. And be sure to shop around to get the best rates available to you.