It can be common for many homeowners to use their as a financial tool. For example, some homeowners may use their home equity for , paying for education, , or other practical matters. Homeowners can tap into their equity in one of two ways: through home equity loans or home equity lines of credit (HELOCs).
While Rocket Mortgage® does not offer home equity loans or HELOCs, we understand that you might still want to learn more about both of these strategies to determine if it makes sense for your financial situation.
Main Differences Between Home Equity Loans And HELOCs
A home equity loan is a second mortgage loan that’s similar to a primary mortgage loan and is paid off with monthly installments. After a homeowner is approved for a home equity loan, they receive their money in a single lump sum payment. Then the homeowner is responsible for paying the loan back on a month to month basis with added interest over a set number of years, depending on the loan term agreement.
On the other hand, a HELOC is a revolving line of credit determined by a percentage of your home equity. Instead of receiving a lump sum of money, a HELOC gives homeowners the opportunity to borrow up to about 75% – 85% of their home’s value. Compared to a home equity loan, HELOCs generally have a lower interest rate and the interest may be tax deductible. Homeowners can take out a HELOC regardless of whether their mortgage has been paid off.
Overall, the main differences between a home equity loan and a HELOC are the ways homeowners receive their funds, the variance in interest rates, and the repayment options. Let’s explain these key distinctions in more detail.
Access To Funds
One of the main differences between home equity loans and HELOCs is the way homeowners receive their funds. For example, home equity loans give homeowners access to their borrowed funds in a lump sum upfront. On the other hand, HELOCs allow homeowners to draw from the borrowed money on an as-needed basis over time.
Fixed Vs. Variable Interest Rates
Interest rates are another key distinction between home equity loans and HELOCs. For example, a home equity loan has a fixed interest rate and a HELOC has a variable interest rate.
A fixed interest rate means that the interest rate of the loan remains the same throughout the whole period of the loan and doesn’t fluctuate as a result of the economy. However, a variable interest rate does fluctuate during the life of the loan depending on the economy and its influences.
This means that when a homeowner takes out a home equity loan, their interest rate payments remain consistent on a month to month basis, but when a homeowner uses a HELOC, their interest rate payments can change each month.
In addition, when comparing the interest rates between home equity loans and HELOCs, HELOCs tend to have slightly lower interest rates than home equity loans.
Finally, another difference between home equity loans and HELOCs are the repayment options. For example, homeowners who take out home equity loans have to make monthly payments on the loan. The amount owed each month as well as the repayment period on the loan can vary depending on the loan terms which can be affected by how much money was borrowed at a given interest rate.
HELOC repayment options significantly differ from the month to month payment of a home equity loan. For example, A HELOC’s repayment can be compared to a credit card, meaning a homeowner can borrow up to a certain amount for the life of the loan, carry a balance from month to month, and make minimum payments on the loan. Typically, HELOCs also have a “draw period,” when a homeowner’s monthly payments will be only for the interest of the loan. This can last around 5 – 10 years before a repayment period of about 10 – 20 years will begin. During this time, a homeowner will make regular payments of the loan with added interest until it is paid off. The amount of money a homeowner can get approved for with a HELOC depends on many factors including the home’s value, how much you owe, and your credit history.
Pros And Cons Of Home Equity Loans
When choosing between a home equity loan and HELOC, it’s important to weigh the pros and cons of both options. Let’s start by focusing on home equity loans.
There are several benefits that come with taking out a home equity loan:
- Your interest rate will be fixed so there won’t be any surprises, allowing you to better budget your monthly payments.
- Typically, interest rates for home equity loans are lower than interest rates for unsecured personal loans or credit cards.
- Your interest payments on your home equity loan might also be tax deductible.
- You’ll receive your money in a lump sum and will have the freedom to use it for whatever you want as soon as you want.
While there are definitely benefits to taking out a home equity loan, there are also some drawbacks and risks involved:
- The main downside involved with a home equity loan is that your home is used as collateral and you could lose it if you fall behind on your payments.
- There are serious risks that come with the possibility that you might tap into too much of your home equity.
- There is potential that you will receive higher interest rates overall. In addition, you will have to pay the closing costs on the loan.
- If you already struggle from time to time with your mortgage payment, this would essentially be a second mortgage payment.
Pros And Cons Of Home Equity Lines Of Credit
Now that we’ve weighed the pros and cons of home equity loans, let’s look at the benefits and drawbacks of a HELOC.
A lot of flexibility comes with taking out a HELOC, and there are many advantages to this option:
- With a HELOC, you can qualify for a low APR. Thus, your interest rates will be lower.
- You can borrow only what you need, and you will only be charged if you withdraw the money.
- There are flexible repayment options, including interest-only payments, and you can choose to have your interest compounded only on whatever money you draw.
- Similar to home equity loans, your interest on a HELOC may be tax deductible.
But with flexibility, comes more risks and disadvantages to taking out a HELOC:
- There is the apparent risk of fluctuating or increased interest rates and payments that come with having a variable interest rate. In addition, some HELOCs have interest-only payments, prepayment fees, or a small fee for setting up the account and an annual fee for keeping it open.
- You could be tempted to spend more money than you have, which can be a problem for some borrowers.
- You could potentially reduce the equity you have in your home and tap into too much of your home equity, like with a home equity loan.
- Similar to a home equity loan, you could also risk losing your home as collateral.
Which Is Right For You?
If you’re deciding between a home equity loan and a HELOC, there are many factors to consider. So, when you decide to borrow, think about what you’ll be borrowing the money for, how much of your equity you want to tap into, what might happen to your interest rates, your long-term financial goals, and the risks involved. You’ll also want to find a lender who can help you learn more and get qualified for a home equity loan or HELOC.
The Bottom Line
If you’re interested in utilizing your home’s equity as a financial tool, you have two different routes to go down. Taking out a home equity loan or a HELOC are both options with benefits and drawbacks. Whether you want to utilize your home equity to pay off your education, consolidate debt, or add onto your home, it’s important you consider your financial situation when choosing between a home equity loan or HELOC. For more tips and finance articles, visit the Rocket Mortgage®.