What’s the Difference Between a Home Equity Loan and a HELOC?

As most of us are aware, one of the best reasons to buy a home is the opportunity to build financial security and wealth through home equity and your property’s increase in value over time. Simply put, home equity is defined as the share of your home that you own outright. In other words, it’s the portion of your home’s value that isn’t mortgaged.

Between paying down your mortgage and market appreciation, you’ve likely been building equity in your home if you’ve owned it for several years. In addition, your home equity may have increased if your property has risen in value due to significant improvements you’ve made. A home equity loan and a home equity line of credit (HELOC) are two types of financing tools that can enable you to capitalize on this ownership stake in your home. Either type of loan can be used for a multitude of purposes, such as financing a remodeling project or home addition, covering educational expenses, buying an investment property, or even paying for a big-ticket purchase like a family vacation.

Both home equity loans and HELOCs can enable you to borrow a considerable amount of money at a significantly lower cost as compared than other financial products, such as credit cards or personal loans. Because your home serves as collateral, these types of loans are determined to be a lower risk for lenders versus those that are unsecured. Accordingly, lenders will usually offer you a better annual percentage (APR), which can enable you to make lower monthly payments, and help save you tens of thousands of dollars on financing charges over the life of the loan. However, it’s essential that you’re comfortable with the fact that your home is on the line when you take out either a home equity loan or HELOC. Because if you fail to make payments, you can put your property at risk of foreclosure.

Although you can use the borrowed funds from a home equity loan or HELOC almost any way you see fit, one of the two products may be more suitable for you depending on your personal situation, your comfort with risk, and your intended use for the money. To get a handle on each of these types of loans and how they may benefit you, here are the basics to know, including the distinct advantages each has to offer:

How do home equity loans and home equity lines of credit work?
A home equity loan is provided to you in one lump sum payment and comes with a fixed interest rate. After you’re approved for a home equity loan, you begin repaying both principal and interest in monthly installments that remain the same throughout the life of the loan. Loan term lengths vary, but generally, you’ll have anywhere from five to 30 years to pay back the borrowed funds.

In contrast, a HELOC is issued to you as a revolving line of credit with a replenishable balance and a variable interest rate. Over the course of time known as the draw phase, you can access funds from this credit line as needed up to your established limit. During this time, you are only required to make interest payments on the money you withdraw. However, the amount of your minimum monthly payment can fluctuate depending on your balance and the current interest rate environment.

As you use the funds from a home equity line of credit, you can repay them and borrow them again, much like a credit card. While draw periods vary across different lenders, they may range from five to 15 years (but are most commonly 10 years). Once the draw period ends, you begin to pay back both the amount you withdrew as well as the accrued interest, typically over 10 to 20 years. During the repayment period, you can no longer tap into this line of credit.

Advantages of a home equity loan (as compared with a HELOC):

Your interest rate won’t increase.
You won’t have to worry about how a rising interest-rate environment will impact your loan, because you have a locked-in APR.

You’ll know precisely what your payments will be every month and when your loan will be repaid.
Because you receive a lump sum and have a fixed APR, your payments on a home equity loan remain the same from month to month. With an established payment schedule, you’ll know exactly when your loan will be paid off. This predictability can make it much easier to budget and plan.

Receiving a finite amount of funds can help you to avoid impulse spending.
The fixed amount you receive from a home equity loan can reduce the inclination to overspend, since you aren’t continually getting access to more funds, as you would when you pay down the balance on a home equity line of credit. Especially if you’re using your home equity loan to consolidate and pay off high-interest debt, you’ll want to avoid racking up more of it.

Cons of a home equity loan:

Home equity loans don’t offer as much flexibility as HELOCs when it comes to both disbursement and repayment.
When you are approved for a home equity loan, you must accept all the funds at one time. You don’t have the option to use only a portion of this money in order reduce your loan payments. In addition, you can’t access more funds as you pay down the loan, as you would with a HELOC. If you find that you need more funds, you’ll need to take out another loan.

You must make payments that include both principal and interest from the outset.
A home equity loan requires that you begin making fixed monthly payments that include both principal and interest that begin after the loan is advanced. In contrast, a HELOC gives you the option to make interest-only payments on the money you use during the draw period.

It’s important to know exactly how much you want to borrow.
Whereas a HELOC can be an ideal solution for emergencies or for expenses that are anticipated but can’t be precisely determined ahead of time, a home equity loan may be more suitable if you know exactly what your expenditures will be. Otherwise, you may end up repaying principal plus interest on funds you didn’t need to borrow. On the flip side, if you don’t take out a home equity loan large enough to cover your expenses, you’ll need to take out a new loan to get access to more funds.

You’ll need to refinance to take advantage of falling interest rates.
While home equity loans offer the advantage of a predictable annual percentage rate (APR), this locked-in rate becomes less favorable in an environment of falling interest rates, or if an improved credit standing could enable you to qualify for a more favorable rate. In either case, you’ll need to refinance for access to a lower rate.

Advantages of a HELOC (as compared with a home equity loan):

You have the flexibility to take out cash as needed – and only pay for what you use.
Unlike a home equity loan from which you receive a lump sum payment, you can take out money from a HELOC as you need it in a series of separate withdrawals. You repay the amount you use plus accrued interest, not the entire line of credit allowable.

You’ll get access to a large amount of money over an extended timeframe while making only minimal payments.
During the draw period of a HELOC, you’re only required to make interest payments on the money you borrow. This option can make your required monthly payments much lower throughout this timeframe, although your payments will increase substantially once the repayment period begins if you only make interest payments during the draw phase of your loan. But initially, it can be much easier to manage payments on a HELOC as compared with a home equity loan, in which payments are spread out evenly over the life of the loan.

You won’t need to know exactly how much you’re likely to spend.
Because you can borrow as much from your credit line as you want up to your approved limit, or choose not to use it at all, a HELOC can be a viable option if you want to have access to cash for emergencies but aren’t in immediate need of funds. It can also make sense if you’re planning for expenses that will require multiple payments over an extended length of time.

You don’t have to take out a new loan to get access to more funds.
Until the repayment period of a HELOC begins, you can draw on your line of credit, pay down the balance, and borrow funds again as needed — all without applying for another loan. In this way, a HELOC operates much like a credit card.

You might be able to convert your outstanding HELOC balance to a fixed-rate loan.
Some lenders offer products that allow you to convert your HELOC balance to a fixed-rate loan when the draw phase ends and the repayment period begins. Others may allow you to convert your balance at any time during the loan’s life.

Cons of a HELOC (as compared with a home equity loan):

A variable interest rate may mean an increase in your APR and monthly payments, especially in a rising interest rate environment.
The APR you pay on a HELOC is directly tied to the prime rate, which is turn based on the most significant interest rate benchmark in the country, the federal funds rate. When the Federal Reserve increases the fed funds rate, the rates for HELOCs rise as well. In addition to a rising interest rate environment, a worsening of your credit profile can potentially result in an increase in your APR.

Fluctuating payments can make it harder to budget.
Because your monthly payments can vary, a HELOC may not be the best financing option for those who live on a fixed income and must closely adhere to their budget.

Your monthly payments can increase dramatically after the draw period ends.
If you make only the minimal (interest) payments during the draw phase of a HELOC, you should be prepared that you’ll need to make substantially higher payments to cover both principal and accrued interest once the repayment period begins. Also be aware that some HELOCs have a balloon payment feature, in which you pay the full balance of your loan once the draw period ends.

Impulse spending can be harder to control.
With access to a large credit line, you can spend as much or as little as you want up to your established limit. What’s more, you can continue to take out funds from their HELOC as you pay down your balance. While access to additional funds could be viewed as advantage, there is also the potential to create more debt if you tend to overspend.

Under certain circumstances, the line of credit can be cancelled.
If you no longer meet the conditions for your loan whether due to a change in your financial situation or a drop in the market value of your property, be aware that the lender has the right to freeze or reduce your credit line in order to prevent a potential loss.

Final considerations:
An important advantage that both home equity loans and HELOCs can offer are potential tax savings under certain conditions. Interest payments on either may provide a tax deduction up to a specified amount, if the borrowed funds are used for home improvements for the property that secures the loan, and the taxpayer itemizes deductions. As the IRS has explained, you’ll need to use the proceeds to “buy, build or substantially improve your home.”  But sure to consult a qualified professional for tax-related advice regarding your personal financial situation.