HELOC vs Home Equity Loan Explained
A HELOC and a home equity loan are both secured by the equity in your home. The main difference between a HELOC and a home equity loan comes down to how you get and use the money.
A HELOC loan is akin to a credit card in that it’s a line of credit supported by the equity in your home that you repay over time. In contrast, a home equity loan consists of taking out a loan against the equity in your home in a lump sum, then repaying it. The home equity loan closes after it’s paid off. Read on to learn more about the difference between the two types of financial instruments that take advantage of the equity in your home.
What is a home equity loan?
A home equity loan is a loan against the equity in your home. Equity is defined as the value of your home as opposed to the outstanding balance on your mortgage. For example, if you have a home that’s worth $225,000 and you owe $100,000 on your first mortgage, you have $125,000 in equity on your home. You can typically take out a second mortgage loan of up to 85% of the available equity in your home. Some lenders go as high as 95%, but most average between 80 to 85%.
The home equity loan cashes out the equity all at once and gives you the funds in a lump sum. You use the money as intended, like any other loan, but your home provides security for the loan. A home equity loan is typically marketed toward homeowners who want a fixed interest rate to renovate their home and want to finance the work. It makes sense to get a home equity loan in this situation because you can borrow a large amount of money at once and improve your home’s value.
Other uses for a home equity loan are paying off credit card debt, paying for education, or buying a vehicle in order to get a lower interest rate. Using a home equity loan for education helps avoid the issues that come with taking out a traditional student loan, and retiring the debt is much easier.
There are several factors that determine if it is best for your unique situation to choose a HELOC, closed-end fixed home equity loan, or a cashout refinance of your first mortgage including the amount of equity in your home, interest rate on your first mortgage, and how much cash you need.
A home equity loan can also be used to lower your down payment and help you avoid private mortgage insurance (PMI) when you purchase a home. Using a home equity loan to purchase a property is called a “piggyback” loan. For example, the 1st mortgage will be at 80% loan-to-value and the 2nd mortgage will be at 90% combined loan-to-value allowing you to allow have to put down the remaining 10%.
Taking out a home equity loan burdens you with more debt and records a 2nd lien on title against your property. You need to make sure that you can handle paying the original mortgage and the home equity loan at the same time. A home equity loan is often called a second mortgage because of this fact. You’ll have to pay down two loans against your home and hope that it retains its valuation if you decide to sell after you’ve taken out the loan. Another drawback to selling your home while you have a mortgage and home equity loan is that you’re left with little in the way of equity to cash out when you sell.
Taking out a home equity loan to resolve other kinds of debt can cause a borrower to get into a cycle known as reloading. The borrower takes out the home equity loan, pays off the debt, then uses the freshly paid-off credit lines to buy more stuff. It’s very easy to get into this cycle, especially if you don’t exercise fiscal discipline.
Unlike a HELOC with a closed end fixed home equity loan you could be making payments on funds that might be just sitting in your bank account unused. With a HELOC you are only making payments on the funds that you are using.
What is a home equity line of credit (HELOC)?
A home equity line of credit is an open-ended loan against the equity in your home. It’s similar to a credit card, which is a line of credit, and works in a similar fashion. The difference between a credit card and a HELOC loan is the fact that the HELOC is a secured loan with your house as the collateral, whereas a credit card has no security. The fact that a HELOC is secured by the equity in your home means that you can get a higher credit limit and a lower interest rate than you would with a credit card.
You access the funds for a HELOC either by a credit card or a check. As you use the line of credit, the amount of money available to you goes down the same as a credit card. Like a credit card, you have to repay what you took out over a period of time. A HELOC stays open for 10 years on average and has an average repayment period of 15 years. You have the option to repay the interest only while the draw period is open, but you’ll have to handle much larger payments once the draw period closes.
Interest rates on a HELOC loan are almost always adjustable, although fixed rates are sometimes available. This can be a drawback, especially if you currently have an adjustable-rate mortgage, as you’ll wind up with two payments that are subject to interest rate fluctuations. It makes more sense to take out a HELOC on a house with a fixed-rate mortgage and maintain some predictability in your monthly payments.
A well-qualified borrower can get a HELOC for up to 90% of their home’s equity and at an interest rate that’s a little higher than the average mortgage interest rate. The requirements and terms for taking out a HELOC loan are similar to that of a home equity loan. They also pose the same amount of risk, and it’s important to consider the reasons why you want to take out a HELOC.
What are the key differences between HELOCs and home equity loans?
Both types of equity loans function in much the same way in that they each use the equity in your home to provide you with funds. They’re both loans that require paying back, but the difference between HELOC and home equity loans is that a home equity loan is more like a second mortgage, whereas a HELOC is more like a credit card. Before you go forward with taking out either type of equity loan product, consider the pros and cons of getting a HELOC and home equity loan.
The differences between a HELOC vs a home equity loan
A home equity loan provides you with a lump sum upfront that you must repay over time. In contrast, the HELOC is a line of credit with a fixed maximum amount that can be borrowed against at any time and for any amount up to the maximum. Paying off a home equity loan has the effect of retiring the loan while the HELOC stays open for borrowing even after it’s been repaid.
A home equity loan features a fixed interest rate over the course of the loan. The interest rate for the HELOC depends on the current rate of interest at the time money was borrowed from the line of credit. It’s possible to have multiple draws at the same time against the line of credit, with each having a different interest rate. The interest rates for both types of loans are usually a little higher than a mortgage because you’re securing the loan against your home. You can also pay just the interest on the HELOC and still draw from the line of credit.
The HELOC can be borrowed against for things like an emergency, home improvement projects, or a major purchase. You can borrow as little or as much as you need as long as you stay under the maximum amount of the credit line. A home equity loan disburses the funds in a lump sum and doesn’t have the same flexibility as a HELOC. If you need more money after getting a home equity loan, you’ll have to take out another loan and further increase your debt load.
Drawbacks to a home equity loan or HELOC
The biggest drawback to taking out either type of loan is the fact you’re borrowing against your primary residence. You’re at risk of losing your home if you fail to repay the loan. Before you take out either type of loan, you need to be certain that you can afford to pay back both your mortgage and the loan.
A home equity loan tends to require more paperwork than a HELOC due to the fact the loan delivers the entire sum in one payment. A HELOC has fewer requirements for application because the borrower is expected to take out smaller amounts against the equity whenever they use the line of credit.
Both types of home equity loans are designed to meet different needs. Someone who wants to renovate their home and needs a lot of money upfront can benefit from taking out a home equity loan, paying for the work, then focusing on retiring the debt over time. In contrast, a HELOC is perfect for someone who needs quick infusions of cash, but doesn’t want to use a credit card because of the high interest rates.
At Griffin Funding, we’re here to talk with you about your plans for your home and determine which type of home equity loan product makes the most sense. Use our online form to request a quote for a HELOC and get started on planning your project today. Griffin Funding offers home equity loans on primary residences, second homes, and investment properties.