Home Equity Loan vs. HELOC | Differences Explained

You have a couple of different ways that your residence can be used as collateral. One is with a home equity loan, the other is a home equity line of credit, also known as a HELOC. Knowing how each one generates income is important in helping you sustain yourself financially. Many people use these methods to eliminate burdensome credit card debt. And yet, others take advantage of these options for other milestones in life, like sending a child to college or performing a major remodel. If your home has enough equity in it, you can borrow against it. What’s more, this is often done at a reasonably low-interest rate. Additionally, your interest payments may be able to be tax-deductible depending on how you used our funds. It’s important to note that while both options result in the same collateral , there are some key differences that you should consider. Let’s discuss each option so that you’re informed enough to make an educated decision.

Home Equity vs. HELOC

Home Equity

As a fixed-term loan, a home equity loan is granted by a lender and given to the borrower. This granting is based on your home’s equity. Many people refer to these types of loans as second mortgages. As such, their interest payments are set on a fixed term. This is highly beneficial to the borrower, as it serves to eliminate any guesswork about repaying. Having a set, reliable payment arrangement makes it easier for the borrower to plan for each month, thus reducing stress over their financials. Home equity loans are sometimes referred to as installment loans . These loans work just like that of a traditional fixed-rate mortgage. The amount of your equity loan is centered on several factors, such as the combined loan-to-value ratio (CLTV). This is normally 80 to 90% of your home’s appraised value. Factors like your payment history and credit score are also taken into account. A lender will consider these to help them establish your equity loan’s interest rate. On average, most home equity loan interest rates are around 5.28%. Once the interest rate is established, it’s generally locked into place, so you can count on your payments staying fixed at a set interest rate. As such, your payments will always be the same throughout the term of your loan. This term can last as little as one year or as many as 30. But regardless of how long your term is set for, you can always look forward to predictable payments each and every month. If you prefer to have a broad view of your finances, a home equity loan is likely to be the better fit for you. And since you are borrowing a fixed amount at a fixed rate, a home equity loan gives you the peace of mind of knowing exactly how much you owe and what your monthly payments will be until your loan is paid off. What’s more, a home equity loan allows you to pay off your loan early or even refinance your loan at a lower rate.

HELOC

Conversely, a HELOC works like a revolving line of credit that functions much like that of a credit card. While a HELOC is also based on the home’s equity, this option lets the borrower use money from the line of credit. This can then be used to make payments as long as the borrower isn’t in default and is current on all payments that are due. Home equity lines of credit (HELOCs) are secured lines of credit—secured by the equity in your home. They operate, in part, like a credit card, so they have a revolving credit line that you can use more than once—as long as you keep up your payments. There are two parts to HELOC terms: the draw period and the repayment period. The draw period is where you can withdraw funds. This period can usually last for up to 10 years. The repayment period may last another 20 years, which would mean your HELOC loan is a 30-year loan. It’s important to note that when your HELOC loan’s draw period ends, you won’t be able to borrow any more money. You will have to agree to make payments while it is the HELOC’s draw period. However, these payments are often small and are typically the same amount as the interest. But once the repayment period starts, your payments will become much higher. The reason for this is that you will now be paying back on the principal. Throughout the 20-year repayment period, you will have to pay back any and all money that you borrowed. This includes interest at a variable rate. The difference in payments is so substantial that it gives many borrowers payment shock . Many people have even been forced to default on their HELOC loans as a consequence of payment shock. When this happens, you could end up losing your home, which if you recall, is the collateral of the loan you agreed to. When you agree to a HELOC, you have the benefit of knowing the maximum amount of money that you’re likely to borrow. This is also the amount of your credit limit. However, it can be hard to clearly determine the overall cost of the HELOC loan. Why? Because you never really know the exact amount of money that you end up borrowing. Moreover, you won’t know the interest rate that you will have to pay. The interest rate of your HELOC loan is dependent on your credit score. On average, most interest rates are around 4.87%. But again, these can vary wildly depending on credit scores.

Why Take Out a Loan?

It’s always important to ask yourself what the purpose of the loan is. A home equity loan is a solid option if you know the exact amount that you need to borrow and for what purpose the money will be used for. Remember, you will receive a guaranteed amount that you will get in full once the loan is advanced. Interest rates aside, HELOCs are also a good option to go with if you don’t know how much you’ll need to borrow or exactly when you will be needing it. Normally, a HELOC gives you continued access to cash for a period of about 10 years on average. And, you can borrow against your credit line, which you’ll have to repay in full or partially. You can always borrow that money again at a later date if necessary. But, you must still be within your HELOC’s draw period. It’s important to mention that you may have a difficult time obtaining a HELOC loan for the foreseeable future. Because of the ongoing COVID-19 pandemic, JP Morgan and Wells Fargo have frozen any new HELOCs from being established. It’s not a stretch to think that other banks could follow suit. Speaking of which, you should be aware that credit lines function as a credit card and be revoked if your financial situation gets tough or the value of your home market declines. If either were to take place, your lender could very well close out your credit line completely. Yes, a HELOC is a great choice for having ongoing access to finances. But if you can’t access those funds due to unforeseen circumstances, you may want to think about a traditional home equity loan.

Summary

It’s important to understand that just because you have the option to borrow against your home’s equity, it doesn’t necessarily mean that you should. If you absolutely must take out a home equity loan, you need to think about a lot of factors: for one, how do you plan on using the money? You should also consider what could happen if the interest rates fluctuate. And what about your long-term financial plans and other outstanding debts? Understandably, many people simply aren’t comfortable with a variable interest rate that comes with a HELOC. They typically prefer the stability and reliability of a home equity loan because they know the exact amount of their payments and what they will owe altogether. Because of these aspects, home equity loans are a lot easier for people to budget around. Unlike a HELOC, which can result in unnecessary spending, the fixed rates of a home equity loan promote wiser use of finances. The temptation isn’t there like it is with a HELOC loan. If you don’t believe that you would be able to resist splurging here and here, you should most definitely avoid a HELOC loan and go with the safety of a home equity loan. You won’t have to worry about putting yourself in a tight spot and possibly defaulting on your payment and losing your home. All of these potentialities can be avoided by choosing a home equity loan. Sources https://www.consumer.ftc.gov/articles/0245-using-your-home-collateral https://www.sciencedirect.com/science/article/abs/pii/S1051137710000434 https://www.bankrate.com/glossary/f/fixed-rate/