If you’ve been making payments on your mortgage, you have likely built up equity in your home. Not only does that mean you’ve paid off a portion of your house, but the equity may also be used as a resource when you need it.
There are two ways to use your home’s equity to your advantage:
- Getting a home equity line of credit, or HELOC
- Borrowing a home equity loan
But which one is best for you? To start, it depends on your unique situation and your goals.
HELOC vs. Home Equity Loan Comparison
In order to understand the differences, along with the pros and cons of each, let’s compare HELOC vs. home equity loan side-by-side.
What Is A HELOC?
A HELOC works something like a credit card, with a maximum borrowing limit and interest. The money you have available on your line of credit is based on your equity, and since you don’t actually borrow the whole amount at once, you pay interest only on the amount you use.
HELOCs typically have a draw period which is the amount of time you can draw from the HELOC, typically 10 years, which provides homeowners with an extended period of time in which to benefit. They also come in two varieties: one where you pay interest only during the draw period and one where you pay principal and interest.
Once the draw period ends, your repayment period can be up to 20 years, during which you could opt to renew your line of credit once you’ve paid it off.
What Is A Home Equity Loan?
A home equity loan, on the other hand, is basically a loan where you borrow against your home’s equity. You’re given the full amount all at once and then pay it back in yearly payments, much like a mortgage. In fact, you may see some financial institutions refer to home equity loans are as “second mortgages.”
The term for a home equity loan can range from five to 20 years, depending.
Advantages of HELOCs
HELOCs offer the following advantages:
Start at lower rates
In general, HELOCs start off at lower interest rates than home equity loans. This is because the rates typically fluctuate over the course of the draw period. That said, it is possible to lock in an interest rate on a portion of what you owe, allowing you to potentially pay lower rates overall.
Pay interest only on what you draw
In addition to the lower initial rate, you pay interest only on the amounts that you draw. This will generally mean you’ll pay very little interest overall if you use the line of credit wisely and pay off balances promptly.
Interest only options
HELOCs can also allow you to pay only the interest during the draw period. This makes your financial obligations very easy during the draw period.
A HELOC is flexible in terms of the amount you borrow, and you can draw on it at a moment’s notice. This makes a HELOC a great way to prepare for unexpected expenses.
Disadvantages of HELOCs
Of course, there are some downsides to HELOCs, including:
The adjustable-rate may start off lower than what you’d get with a home equity loan, but it has the potential to grow much higher. This means your interest payments could increase over time.
Not being ready for the payments later
Once the draw period is over, you may be slammed with a sudden balance to pay off. This means your monthly expenses go up as you work on paying off any balance you still owe on the line of credit.
As with a credit card, you need to be careful to use your HELOC responsibly. Homeowners who make payments only on interest will face the shock of a large balance due when the draw period ends.
Advantages of Home Equity Loans
Home equity loans are fairly straightforward, and they offer these advantages:
Fixed interest rates
The fixed interest rate is one of the greater advantages of home equity loans. If you’re able to lock in a low rate for the life of the loan, you’ll be able to keep your monthly payments consistently low.
The consistency offered by a home equity loan makes sure you pay it off, whereas a HELOC could run the risk of slamming you with a large balance and minimal time to pay it off.
Lump sum payment
With a home equity loan, you get the entire amount as a lump sum, making it ideal for tackling large purchases and home improvements.
Disadvantages of Home Equity Loans
Downsides of home equity loans are as follows:
Higher monthly obligations
Overall, the required payments for your home equity loan will be higher than a HELOC, which may offer interest only options. If you have a shorter loan term, that will mean higher monthly payments and could pose an issue if you’re already paying off other debts.
Risk of ending up upside down
Since the amount is given to you in one lump sum amount, there is a risk that you’ll end up owing more than the value of your home. If your home decreases in value, the equity you’d have built up would diminish, putting you upside down in the loan.
HELOC vs. Home Equity Loan
HELOCs allow you to draw only a small amount against your home’s equity, making them ideal for handling random large expenses such as repairs or medical work. Used responsibly, their flexibility makes these types of sudden costs more manageable. They’re also good for home improvement projects where the total cost may not be immediately obvious.
Home equity loans are great for planned one-time expenses. They could also be used to consolidate debt, paying off high-interest obligations and consolidating them into a single loan with a comparatively small fixed rate.
Ultimately, the type of home equity financing you choose depends on what you intend to accomplish with it.