Home Equity Loan vs. Line of Credit: Pros and Cons
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5 MIN READ
Published July 15, 2024 | Updated July 15, 2024
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If you’re a homeowner facing a major home renovation or want to consolidate debt, you may be able to borrow against the equity in your home. Home equity loans and home equity lines of credit (HELOCs) are two ways you can do that.
While both these options have some similarities, they also have some key differences that make them suitable for different types of borrowers. Read on to learn more about home equity loans vs. line of credit and their pros and cons.
Home Equity Loan | HELOC | |
Disbursement | Lump-sum | Withdraw as needed during the draw period |
Interest | Fixed interest rate | Variable interest rate |
Repayment | Fixed monthly installments over a set period | Interest-only payments during the draw period |
What Is a Home Equity Loan?
A home equity loan is secured by your home and is often called the second mortgage. If approved, you’ll get a lump sum amount, and most lenders will allow you to borrow up to 80% of the equity you have in your home.
Typically, home equity loans have a fixed interest rate and terms of up to 15 years. The interest on the loan is tax deductible only if you use the funds to “buy, build, or substantially improve” the home. For example, if you use the funds to pay off credit card debt, the interest on the home equity loan won’t be tax deductible.
You’ll pay the amount you borrowed with interest through monthly payments. The current average interest rate is 8.60% for home equity loans, which is much lower than personal loans. However, since the loan is secured against your home, you risk foreclosure if you default.
What Is a Home Equity Line of Credit?
A home equity line of credit (HELOC) is also secured against your home. This is a line of credit, so you’ll be able to borrow funds as you need them for a predetermined amount. You’ll only pay interest on the amount you borrow.
HELOCs usually remain open for a fixed term. The loan is amortized at the end of the draw period, so you’ll have to make monthly payments for a set term. The main benefit of this type of financing is that you only pay interest on what you borrow.
Like home equity loans, the interest you pay is tax-deductible if you use the funds to buy, build, or substantially improve your home. However, HELOCs usually have variable interest rates, much like credit cards. The average HELOC rate is 9.17% as of June 2024.
Pros and Cons of Home Equity Loans
Understanding the differences between home equity loans vs. lines of credit and their pros and cons will make it easier for you to pick the right option for your financial situation.
Pros
- Fixed interest rate
- Fixed payments each month provide stability for your budget
- Lower chances of impulse spending since you’ll receive a lump sum amount upfront
Cons
- You can’t borrow more if you need money later
- If you default on the loan, you risk foreclosure
- You may end up paying more in interest over the life of the loan if you choose a longer term, even with low interest rates
- You’ll need to refinance your home equity loan if you want a lower interest rate
Pros and Cons of Home Equity Lines of Credit
HELOCs offer flexibility but also come with a few risks. Consider these HELOC pros and cons.
Pros
- You can borrow money whenever you need for an emergency
- You can choose how much to borrow and when
- You’ll only pay interest on the amount you borrow
- Interest rates are variable, so you don’t need to refinance if rates drop
Cons
- Payments are harder to budget
- Your rates can go up if market conditions change
- You risk foreclosure if you default
- You may end up impulse spending since the money is available to borrow whenever you want
Key Differences Between Home Equity Loan Vs. Line of Credit
While home equity loans and lines of credit both allow you to tap into your equity, there are some key differences between the two.
- With a HELOC, you can use the funds for an emergency up to the available credit limit. With a home equity loan, you can only borrow a fixed amount, and you’ll get it upfront.
- Home equity loan rates are fixed, while HELOCs come with a variable rate of interest.
- You make interest-only payments with a HELOC during the draw period. With a home equity loan, you’ll pay interest on the entire amount, whether you use it or not. Essentially, you’ll make two separate payments each month: mortgage payments for your first mortgage and home equity loan payments.
- Home equity loans are repaid with fixed monthly installments. With HELOCs, you’ll only pay interest during the draw period and will then repay the principal when that period ends.
What Are the Requirements for Home Equity Loans and Lines of Credit?
Home equity loans and HELOCs usually have the same eligibility requirements, such as:
- Credit History: You’ll need a strong history of paying all your bills on time.
- Credit Score: Most lenders will require a credit score of at least 620. You’ll need a higher credit score to qualify for a lower rate.
- Debt-to-Income Ratio: Your debt-to-income ratio (DTI) should not exceed 50%. The ideal DTI is 43% or lower.
- Loan-to-Value Ratio: You must have at least 15% to 20% equity in your home. Most lenders require a loan-to-value (LTV) of no more than 80% to 85%.
How To Choose Between Home Equity Loans and Lines of Credit?
When deciding between a HELOC and a home equity loan, think about your overall financial situation, borrowing purpose, and how you plan to use the funds. Here are a few tips to help you decide:
- If you need to borrow a large amount upfront, a home equity loan is a better choice.
- If you have a history of impulse spending on credit cards, a home equity loan is a safer choice.
- A home equity loan is also a good choice if you want to use it for debt consolidation for high-interest debt.
- Choose a HELOC if you have a longer home improvement project and don’t know how much you’ll need.
How To Get a Home Equity Loan or a Line of Credit?
A lot of lenders offer the ability to apply online for home equity loans and lines of credit. Here are the steps you’ll generally need to follow to apply for either of these:
- Decide whether you want to apply for a home equity loan or a line of credit.
- Shop around and compare loan offers from online mortgage lenders, banks, and credit unions. Prequalify with a few lenders to check the mortgage rates you qualify for.
- Gather relevant documents, such as tax returns, W-2s, and pay stubs.
- Fill out the application form and apply for the loan. The lender will review your credit, ability to repay, and income to make a decision.
Should I Get a Home Equity Loan or a Line of Credit?
Think about how much you need to borrow and how you plan to use the funds before choosing between the two options. It’s also a good idea to consider repayment terms, fees, and interest rates when you weigh your options.
Regardless of the option you choose, you should take a good look at your budget to ensure you’ll be able to repay what you borrow comfortably. The repayment schedule for home equity loans and HELOCs is very different, so be sure you’ll be able to stick to it until the end of the repayment period.
If you feel that your mortgage loan is unaffordable or if additional debt will put a strain on your budget due to higher interest rates, we recommend refinancing your primary mortgage instead.