Comparing HELOC vs. Home Equity Loan
What You Should Know
- Both options allow you to receive a low interest rate loan through your home equity.
- Borrowing from your home equity will increase your monthly mortgage payment.
- HELOC payments will change with the interest rate, while home equity loans are fixed-rate.
- If you constantly miss payments on either option, your lender may foreclose your home.
A HELOC and home equity loan are both ways to borrow cash from your home's value. They are amongst the lowest interest rate loans available. Over time you build equity by paying off your mortgage and increasing your home's value. The longer you own your home, the more equity you usually have. When it comes time to borrow money, there are a few ways you can do so, each with pros and cons. In this article, we will compare HELOCs and home equity loans.
HELOC vs. Home Equity Loan
Both options allow you to borrow from your home equity at a low interest rate. The interest rates are low because your home secures each option. If you consistently miss payments, your lender can foreclose your home. The primary difference between the two is that a HELOC provides you with more flexibility for a slightly higher interest rate.
Both options typically allow you to borrow up to 80% to 85% from your home equity. This is known as the loan to value (LTV). For example, imagine your home is worth $800,000 while your mortgage balance is $500,000. You have borrowed up to 62.5% (=500,000/800,000) of your home's value. As a result, you could borrow an additional 17.5% to 22.5% from your home equity. This translates to a low interest rate loan ranging from $140,000 to $180,000 maximum. The continuing section will further explain your options to access home equity.
|HELOC||Home Equity Loan|
|Lower Interest Rate||❌||✅|
|Interest Only Payments||✅||❌|
|Longer Term Length||❌||✅|
You can think of a HELOC as a credit card attached to your home. Similar to a credit card, you will only need to pay interest on the amount borrowed. A HELOC provides flexibility because you will not accrue interest if you don't withdraw from the account. Similarly, you can draw a portion from the account and only need to pay interest on that amount. Many homeowners open a HELOC as a precautionary emergency account should they run into financial troubles. This is because there is no interest paid on unused amounts.
A HELOC also provides you with more flexibility on repayments. You can make interest-only payments or pay off the principal plus interest. This can be helpful if you experience financial difficulties and cannot afford to make total payments. In exchange for the flexibility, HELOCs tend to have slightly higher interest rates than home equity loans. Also, remember that your home secures the loan. If you consistently miss payments, your lender could foreclose your home.
Tip: How to Calculate Your Home Equity
Home equity is the amount of your home that you own. It’s the difference between debts tied to your home and the current market value of your home. You can access your home equity by downsizing or though a HELOC or home equity loan. The latter options are best if you don’t want to sell your home. To calculate your home equity, you will need two things;
- The current market value of your home
- Any debts secured to your house’s title
To calculate your home equity you simply have to subtract any debts from your home’s current market value. If your home is valued at $800,000 with $500,000 of debts, your home equity would be $300,000.
Home Equity Loan Explained
A home equity loan provides less flexibility than a HELOC in exchange for a better interest rate. There is less flexibility for both withdrawals and repayments. Initially, you receive the total home equity loan upfront. This lump sum will also begin to accrue interest immediately, and you will need to start making monthly payments. This contrasts with the HELOC, allowing you to withdraw funds as needed. A home equity loan is a good option for those who know they'll need the money immediately.
On the repayment side, home equity loans don't tend to offer interest-only payments. Instead, you'll be required to make monthly payments that include both principal and interest. These payments will be the same each month for the entirety of the loan, which can be helpful for budgeting purposes. As with a HELOC, if you consistently miss payments, your home could be foreclosed.
Comparing Home Equity Loan vs. HELOC
The primary themes of this article have been that HELOCs provide more flexibility while you receive more predictability and a better interest rate with home equity loans. This section will further explain the differences to help you determine the best option.
|Home Equity Loan||HELOC|
|Interest Rate||Lower||Around 1.00% higher|
|Fixed vs. Variable Rate||Fixed rate||Mostly variable|
|Withdrawals||Up-front lump sum||As needed|
|Repayments||Principal plus interest||Interest only period|
|Term Length||10 to 30 years|
|Speed of Funding||Two to six weeks||Two weeks to two months|
Home equity loans tend to offer a lower interest rate because they are considered less risky. This is because you immediately receive the total loan amount compared to a HELOC, where you can choose when to withdraw the funds. As a result, home equity loans may have higher monthly payments, but you'll ultimately pay less in interest. At the time of writing this article, Bank of America’s HELOC rate can exceed 1.00% higher than a home equity loan (cash out refinance).
Fixed vs. Variable Rate
HELOCs tend to have variable interest rates, while home equity loans offer fixed rates. This means that the interest rate on a HELOC could increase or decrease over time, while the rate on a home equity loan will stay the same. Prime rate increases will also increase your HELOC payment while a fixed home equity loan will not be affected.
- HELOC: Most likely variable rate, although there are some fixed-rate options. Your payment will change with interest rates in a variable rate mortgage.
- Home Equity Loan: Almost always fixed rate. You will have the same interest rate throughout your whole term and your payment amount won’t change.
HELOCs provide more flexibility when it comes to withdrawals because you can choose when and how much to withdraw. This is helpful if you only need to cover a small expense or want to have the option to withdraw more money in the future.
- HELOC: You can make withdrawals as needed up to the maximum amount of your credit limit. If you pay back a portion, you can withdraw it again in the future.
- Home Equity Loan: You will receive the total loan amount upfront.
Home equity loans offer more predictability when it comes to repayments because you will make the same monthly payment for the duration of the loan. This can be helpful for budgeting purposes.
- HELOC: You can choose to make interest-only payments or pay off the principal plus interest each month.
- Home Equity Loan: You will pay off the monthly principal plus interest.
Term length is the time you have to pay off your loan. At the end of your term, the debt will be settled. HELOCs tend to have shorter terms than home equity loans.
- HELOC: There are two phases of a HELOC; the draw and repayment phase. The draw phase typically lasts five to ten years. During this period, you can make interest-only payments if you prefer. Afterward, the repayment phase ranges from 10 to 20 years. In the repayment phase, you can't withdraw more and must pay the interest and principal with each payment.
- Home Equity Loan: There is only one phase of a home equity loan. While the term length varies by lender, they typically last 10 to 30 years.
Speed of Funding
HELOCs offer a quicker turnaround time for funding than home equity loans. This is because the approval process is typically faster, and you only withdraw the funds as needed.
- HELOC: The approval process can take two to six weeks.
- Home Equity Loan: The approval process can take two weeks to two months.
HELOCs and home equity loans are both secured by your home. If you consistently miss payments, your lender could foreclose on your home.
- HELOC & Home Equity Loan: Your home secures the loan, and you could lose your home if you consistently miss payments.
How to Get a HELOC or Home Equity Loan
HELOCs and home equity loans are available through most banks and credit unions. The process for getting approved is similar to other types of loans. You'll need to submit an application, provide financial documents, and undergo a credit check. Most lenders will have the following requirements:
- Home equity exceeding 20%
- Secure and predictable income history (more than two years)
- A credit score above 600
Note that these are the minimum requirements to receive a HELOC or home equity loan. You will receive lower interest rates by exceeding them. It's also essential to compare offers from multiple lenders to find the best rates and terms. To save time, you can have a mortgage broker find the best rates on your behalf. Once you've found a lender you're comfortable with, you can begin the application process.
The application process usually begins with an online pre-approval. Here you will submit information such as your annual income, debts, and home value. The lender will use this information to give you a preliminary idea of how much you can borrow and what interest rate you qualify for.
If you're pre-approved, the next step is to submit a formal application. This is where you will provide more detailed financial information such as tax returns, bank statements, and investment account balances. The lender will also order a home appraisal to confirm the value of your property.
Once the formal application is complete, the underwriting process begins. This is where the lender reviews your financial information and makes a final decision on whether or not to approve your loan. If everything looks good, you should receive a loan commitment letter outlining the terms of your loan.
The final step is to close on your loan and access your funds. This process usually takes about two weeks. Once everything is finalized, you'll receive the money in one lump sum. You can then start using it for whatever purpose you need.