Home Equity Loan vs Home Equity Line of Credit: Which is Better for You?

Homeowners looking to tap into their home’s equity often face a choice between a home equity loan or a home equity line of credit (HELOC). Both allow you to leverage your home’s value to get cash, but they work differently In this comprehensive guide, we’ll explain the key distinctions, pros and cons, and help you determine which option may be better for your needs

Home Equity Loan Overview

A home equity loan provides a lump sum of cash upfront, which you pay back over a fixed term at a fixed interest rate – just like a mortgage.

Here are the key features

• Fixed amount – You borrow a set amount upfront based on your home’s equity and approval. Common loan amounts range from $10,000 to $200,000.

• Fixed term – Repayment terms are generally between 5-30 years. Longer terms mean lower monthly payments but higher interest costs over the life of the loan.

• Fixed rate – The interest rate is locked in for the entire repayment term, so your monthly payments don’t fluctuate.

• Fixed payments – You pay the same principal and interest payment each month over the entire loan term. This makes budgeting easy.

• Collateral – The loan is secured by your home, meaning the lender can foreclose if you default. You must have sufficient equity to qualify.

• Costs – Closing costs range from 2-5% of the loan amount. There may be early repayment penalties if you pay off the loan before maturity.

HELOC Overview

A home equity line of credit (HELOC) provides flexible access to a revolving credit line secured by your home’s equity. Here are the key features:

• Credit limit – You’re approved for a set credit limit based on your home’s equity and creditworthiness, often up to 85% of your home’s value.

• Draw period – During the draw period, usually 10 years, you can access funds as needed up to your credit limit.

• Interest-only payments – You make monthly payments on any outstanding balance, but you only pay interest during the draw period.

• Variable rate – The interest rate is variable and adjusts periodically based on market conditions. Your payments fluctuate accordingly.

• Access – After the draw period, you can no longer take out new funds, but may have an additional 10-20 years to repay the balance.

• Collateral – The line of credit is secured by your home, meaning the lender can foreclose if you default. You must have sufficient equity to qualify.

• Costs – Upfront costs are generally lower than a home equity loan, but you pay closing costs when you open the HELOC and interest on any outstanding balance.

Now let’s dig into the pros and cons of each option.

Pros and Cons of Home Equity Loans

Pros

• Fixed predictable payments – This makes budgeting much easier, especially for borrowers on a fixed income.

• Lower impulse spending risk – Because you receive the funds upfront in a lump sum, there’s less temptation for impulse spending up to a credit limit over time.

• May offer lower rates – Home equity loans sometimes offer slightly lower interest rates than HELOCs.

• Consolidate debt – The lump sum allows you to consolidate and pay off higher-interest debt all at once.

Cons

• Less flexibility – You can’t easily access more funds later if an unexpected need arises. You would need to apply for another loan.

• Potential early repayment penalties – If you pay off the loan early, some lenders may charge prepayment penalties.

• Higher closing costs – Upfront closing costs are generally higher than a HELOC.

• Can’t benefit from rate drops – You get a fixed rate for the term, so you can’t take advantage if rates fall later.

Pros and Cons of HELOCs

Pros

• Ongoing access to funds – You can access more funds anytime during the draw period as needs arise up to your credit limit.

• Lower upfront costs – Opening costs are generally lower compared to home equity loans.

• May offer lower initial rates – HELOC rates are often lower than home equity loans, at least initially.

• Variable rates – If rates fall, your interest costs decrease. You can benefit from market fluctuations.

Cons

• Payments fluctuate – Since the rate is variable, your payment amount changes making it harder to budget.

• Higher long-term costs – Rates may rise over time, increasing your total interest costs.

• Credit line can be frozen – The lender may freeze or reduce your credit limit if home values decline.

• Risk of overspending – The ongoing access to funds increases impulse spending risk up to your limit.

• Payment shock – When the draw period ends, principal and interest payments spike substantially.

As you can see, each product has tradeoffs. Now let’s look at some scenarios where one option may be preferable over the other.

When a Home Equity Loan Makes Sense

A home equity loan tends to work better if:

• You need a fixed amount for a major planned expense like a home remodel.

• You want to consolidate high-interest debt with fixed repayment terms.

• You need funds to start a business and want fixed loan payments.

• You have concerns about overspending with an open line of credit.

• You are on a fixed income and want predictable loan payments.

• You can qualify for a lower fixed interest rate than a HELOC.

• You plan to stay in your home long enough to pay off the loan term.

When a HELOC Makes More Sense

A HELOC is generally a better option if:

• You have ongoing but variable expenses for which you need funds.

• You want an emergency credit line for unexpected costs.

• You are disciplined and less prone to overspending with access to a credit line.

• You may sell your home before paying off a longer-term home equity loan.

• You want to benefit from interest rate fluctuations over the draw period.

• You have an uneven or seasonal income and like making interest-only payments when funds are tight.

• You need the flexibility to borrow lump sums as needed up to your credit limit.

Which Has a Faster Loan Process?

HELOCs are often able to close more quickly than home equity loans. Lenders advertise HELOC processing times as fast as 2-4 weeks, while home equity loans take 4-6 weeks on average. However, both ultimately depend on the amount borrowed, property values, and your specific qualifications.

Alternatives to Consider

If you need funds but are unsure about tapping your home equity, some alternatives to consider include:

• Cash-out mortgage refinance – If rates are lower, you may be able to refinance and take cash out of your lower mortgage balance.

• 401(k) or life insurance loan – You can borrow against your own 401(k) or from a whole life insurance policy.

• Low-rate credit cards – Cards with 0% intro APR offers can provide an interest-free loan if paid off quickly.

• Personal loans – Unsecured personal loans typically have higher rates but don’t put your home at risk.

• Government loans – Low-interest loan programs may be available, such as USDA, SBA, or VA loans.

Each option carries different terms, rates, qualifications, and risks to weigh carefully.

The Bottom Line

When used prudently, both home equity loans and HELOCs allow homeowners to leverage their equity for access to funds at relatively low interest rates. Shop multiple lenders and compare total costs. Be cautious about borrowing more than you can comfortably afford to repay. A mortgage broker can help you evaluate which product aligns better with your financial situation and goals.