HELOC vs Home Equity Loan - Which Option is Right for You?
- When a HELOC is Better than a Home Equity Loan
- When a Home Equity Loan is Better than a HELOC
- Home Equity Loan and HELOC Comparison
Home equity loans and lines of credit (HELOC) are similar in that both allow you to borrow money using the equity in your property without refinancing your existing first mortgage. Borrowers can use both for numerous purposes including home remodeling, paying off credit card debt or buying a second home or investment property. The biggest difference between a home equity loan and HELOC is that with a home equity loan you receive the entire loan proceeds amount up-front when you obtain the loan as compared to a HELOC that enables you to borrow money from, or draw down, the line of credit as needed, and then repay the line, as many time as you want.
Additionally, the initial interest rate for a HELOC is typically lower than for a home equity loan but it is subject to change over time. Plus with a HELOC you typically only pay interest and no principal on the outstanding loan balance during the first several years, which results in a lower monthly payment, while a home equity loan requires borrowers to pay both principal and interest over the entirety of the loan.
So how do you determine if a home equity loan or HELOC is better for you? The answer depends on your situation and financial objectives. Below, we review when each option makes sense for borrowers and provide a table that compares their key attributes so you can select the financing alternative that is right for you.
If you want to have the ability to borrow against the equity in your property but you do not have a definitive use of proceeds or immediate need for the money, then the home equity line of credit is the right option because it allows you to draw down the line only when you need the money. The HELOC also allows you to draw down, pay off and then draw down the line an unlimited number of times, providing greater financial flexibility than a home equity loan.
The HELOC also typically has a lower monthly payment than a home equity loan because the interest rate tends to be lower and you typically pay only interest and no principal during the first ten years of the line. Interest rates are subject to change, and possibly increase with a HELOC, so there is more potential risk as compared to a home equity loan with a fixed interest rate.
Finally, if you know you are going to pay-off the line within a set period of time such as within three-to-five years, before the end of the loan term, a HELOC is likely the better option. This is because you benefit from the lower interest rate and monthly payment at the beginning of the line of credit but you minimize the risk your interest rate and payment increase by paying off it early.
If you have a definitive use of proceeds for the loan and are concerned about interest rates increasing, then the home equity loan is the right option because it allows you to borrow money at a fixed interest rate. Although you lose the financial flexibility associated with a HELOC, you receive all of the loan proceeds up front and also eliminate the risk that your mortgage payment increases if interest rates rise in the future.
Additionally, if you do not intend to pay off the loan balance early, then a home equity loan is likely the better option because it eliminates the interest rate risk for the entire loan term. If you intend to pay off the loan early, shortening your loan term mitigates the interest rate risk and a line of credit may be the better option.
The downside to a home equity loan is that you borrow the entire loan amount up-front even if you do not have a use for all of the loan proceeds and you cannot use the loan to borrow more money if you pay back all or part of the outstanding balance. In that case, you would need to obtain another home equity loan which may be challenging if you have not completely paid off your original home equity loan. In short a home equity loan provides more certainty and lower risk than a HELOC but less financial flexibility.
The table below compares the key features of a home equity loan and a HELOC. As illustrated by the table, both financing options enable you to take cash out of your home and have similar borrower qualification requirements such as borrower debt-to-income ratio and maximum combined loan-to-value (CLTV) ratio. Both are also types of second mortgage, which means your first mortgage is paid off before the home equity loan or HELOC in the event of a default. Additionally, both offer borrowers significant control over how they spend their loan proceeds.
The biggest difference between the two is that a HELOC provides greater financial flexibility because you can draw down and repay the line as much as you want. This feature also enables you to better control your monthly loan payment. For example, if you pay down your line, you lower your monthly payment. Another difference is that you are not required to receive all of your loan proceeds at closing with a HELOC. Although a home equity loan provides less flexibility, it offers more certainty because your interest rate is fixed. Even though the interest rate for a home equity loan is usually higher than a HELOC at the beginning of the loan you avoid potential payment shock if rates increase. Plus, with a home equity loan, you are paying down your loan balance with every monthly payment, which also helps you manage risk.
So choosing a home equity loan or a HELOC comes down to do you value flexibility or certainty? Review the table below to determine which financing option best meets your personal and financial goals.
|Home Equity Loan||Home Equity Line of Credit|
|Loan Proceeds Received||Up-front||As Needed|
|Ability to Borrow Money Over Time||No||Yes|
|Typical Interest Rate Type||Fixed rate||
|Relative Interest Rate||Higher||Lower|
|Interest Rate Can Increase||No||Yes (during first 10 years)|
|Relative Monthly Payment||Higher||Lower|
|Monthly Payment Can Increase||No||Yes (during first 10 years)|
|Typical Term||15 years||25 or 30 years (ability to draw down line during first 10 years and the line converts into an amortizing loan for last 15 or 20 years)|
|Use of Proceeds||Borrower determines||Borrower determines|
|Maximum Combined Loan-to-Value (CLTV) Ratio||~80% - 90%||~80% - 90%|
|Maximum Debt-to-Income Ratio||~55%||~55%|
|Position / Seniority||Second mortgage||Second mortgage|