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HELOC vs. home equity loan: Tapping your equity when rates are high
Your home builds value, or equity, from a combination of paying down your mortgage and rising real estate prices. This equity only becomes available when you sell the house or borrow against it. And as mortgage rates have increased, fewer people are considering selling or refinancing.
Home equity lines of credit and home equity loans are designed to allow you access to the value of your home right now but in different ways.
Which of these home equity products is right for you? The answer is in the details of how HELOCs and HELs work, what you plan to do with the funds, and how you want to repay the loan.
Read more: How to buy a second home
How to calculate your home equity
The first step in understanding how much you can borrow is calculating how much available equity you have. A mortgage lender determines a certain percentage of the difference between your home's appraised value and the balance on your mortgage. Lenders often loan a total of 80% to 85% of your equity.
For example, using an 85% equity lender limit, a $300,000 home with a $150,000 mortgage balance would amount to a 50% loan-to-value ratio. Subtract the lender’s limit of 85% from the 50% LTV, and a borrower can access up to 35% of their home’s total value.
The calculation:
$300,000 home value - $150,000 mortgage balance = $150,000
150,000 / 300,000 = 50% loan to value
85% loan-to-value - 50% = 35%
$300,000 X 0.35 = $105,000
Dig deeper: What is a second mortgage, and how does it work?
What is a HELOC?
A home equity line of credit, or HELOC, is a revolving credit account that allows you to make on-demand withdrawals from an approved balance limit.
It is much like a credit card, but because it is guaranteed by your home, it's likely to have a lower interest rate than a credit card. You draw from the line of credit as you wish and repay it over time.
The interest you pay on a HELOC can be tax deductible if you use the equity proceeds to "buy, build, or substantially improve the residence," according to the IRS.
Read more: How to get a HELOC
How a HELOC works
HELOCs are like credit cards in another way: They generally have variable interest rates and minimum-required-payment amounts that change. That's because you may draw from the line of credit in various amounts over time, so your balance and your interest rate are likely to vary.
Tip: Some lenders allow you to convert at least a portion of the remaining balance on a variable-rate HELOC to a fixed interest rate. It's a good option to shop for.
A HELOC will have a draw period (generally 10 years) and a repayment period (typically 20 years). You may be given the option to pay only interest on any balance during the draw period. During the repayment period, principal and interest payments kick in.
Dig deeper: How do fixed-rate HELOCs work, and which lenders offer them?
Who should get a HELOC?
HELOCs are suitable for cash needs that change over time. That might include unexpected expenses, home improvements that you tackle one at a time or medical bills such as out-of-pocket costs not covered by insurance.
Read more: How much house can I afford?
Pros and cons of HELOCs
Pros
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You can draw from the credit limit as you need it. That can reduce your interest expense.
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Optional conversion to a fixed interest rate.
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If interest rates are falling, your payment may be reduced.
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Interest paid may be tax deductible.
Cons
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Not all lenders offer HELOCs.
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Your home is held as security for the amount you borrow.
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Monthly payments will increase when principal payments are due.
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A variable interest rate means higher payments if interest rates rise.
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A lender can shut off credit lines at their discretion.
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Annual or early closure fees may apply.
What is a home equity loan?
A home equity loan, or HEL, is a second mortgage where a portion of your home's equity is delivered to you in a lump sum. A home equity loan generally has a fixed interest rate, and as with your primary mortgage, you pay the loan amount off over several years.
And like a HELOC, the interest you pay on the home equity loan may be tax deductible.
How a home equity loan works
In the example above, rather than giving you access to draw on that $105,000 line of credit, you would receive up to $105,000 in a lump sum.
Who should get a home equity loan?
Tapping a lump sum of home equity may be appropriate for significant expenses, such as major home renovations, repairs, or debt consolidation.
Tip: Remember, your home is used as collateral for a home equity loan, so paying off unsecured debt, like credit cards, with a home equity loan is probably not a good idea.
Pros and cons of home equity loans
Pros
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Getting the money as a lump sum is helpful when planning large expenditures.
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A fixed interest rate means your monthly payment won't change.
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Interest paid may be tax deductible.
Cons
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Repayment begins shortly after the lump sum is issued.
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Your home is held as security for the loan.
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Closing costs may be higher than for a HELOC.
Learn more: Cash to close — What you'll owe on closing day
How to qualify for a HELOC or home equity loan
Specific loan requirements vary by lender, but generally, home equity loans and HELOCs require a borrower to:
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Have a FICO credit score of 680 or higher.
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Show a history of good credit and proof of sufficient monthly income.
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Obtain a home appraisal showing the current market value of the home.
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Have at least 15% to 20% equity in the house.
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Have a debt-to-income ratio (DTI) of 43% or less.
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Show proof of in-force homeowners insurance.
Tip: Lenders may charge origination fees and other closing costs on a HELOC or HEL. Ask about all possible application fees, annual charges, early account closing fees, and other one-time or ongoing expenses. Shop with multiple lenders to find the lowest interest rate and the fewest fees.
A cash-out refinance is another option
Another way to tap the equity in your home is with cash-out refinancing. Before refinancing, you may need more than 20% equity in your home, though some refinance programs offer much lower equity requirements. You'll want prevailing interest rates close to or below your current mortgage rate.
A cash-out refinance has the advantage of a single monthly payment, though because you are adding to what you owe, it will be higher than your original mortgage payment. The interest rate on a cash-out refinance is often higher than traditional refinances, and the closing costs on a cash-out refinance are often higher than for HELOCs and home equity loans.
When considering a cash-out refinance, a HELOC, or a home equity loan, you'll want to consider which option has the lowest closing costs and the most favorable pay-back terms.
Dig deeper:
HELOC vs. home equity loan FAQs
Is a home equity loan the same as a HELOC?
No, home equity loans and HELOCs are two different types of second mortgages that help you tap your home equity. A home equity loan gives you money in one lump sum, and a HELOC is a line of credit you can use when you need the money (sort of like a credit card).
What is the difference between a home equity loan and a HELOC?
Both home equity loans and home equity lines of credit (HELOCs) are types of second mortgages. With a home equity loan, you receive the borrowed money in one lump sum. A HELOC is a line of credit, meaning you can borrow money as you need it — and only pay interest on the funds you actually end up using. Although there are exceptions, a home equity loan usually has a fixed interest rate, and a HELOC typically has a variable rate.
How is a $50,000 home equity loan different from a $50,000 home equity line of credit?
If you take out a $50,000 home equity loan, you will receive all of the money at once and pay interest on the full amount. With a HELOC, you can withdraw money whenever you need it. For example, you may take out $10,000 to remodel your kitchen, then $20,000 to replace your roof, and never touch the remaining $20,000.
