Should You Get a Home Equity Loan or HELOC? Weighing the Pros and Cons

As mortgage rates continue to climb, many homeowners are looking for ways to access their home equity without refinancing their existing mortgage. Two popular options are home equity loans and home equity lines of credit (HELOCs). While both allow you to leverage your home’s equity, there are some key differences between these products that you should understand before deciding which is right for your needs.

Before diving into the specifics of home equity loans and HELOCs, it’s helpful to understand what home equity is in the first place.

Your home’s equity is calculated by taking the current market value of your home and subtracting any outstanding mortgage debt For example, if your home is worth $300,000 and you owe $150,000 on your mortgage, your equity is $150,000 This represents the portion of your home that you fully own.

Lenders allow you to borrow against a percentage of your equity, up to 80-85% in many cases. So in the example above, you could potentially borrow up to $120,000 against your $150,000 in equity. The amount you can borrow depends on factors like your credit score, debt-to-income ratio, and loan-to-value ratio.

Borrowing against your equity converts a portion of it into debt. This can be an effective way to access funds when you need them. However it also means you are putting your home up as collateral for the loan.

What is a Home Equity Loan?

A home equity loan provides you with a lump sum of cash upfront. It works similarly to a mortgage or auto loan – you receive the full loan amount at closing and then repay it over a fixed term with fixed monthly payments

Home equity loans have set repayment terms, often 10, 15, 20 or 30 years. The interest rate is also fixed for the life of the loan. This provides predictability in your monthly payments.

The main pros of a home equity loan include:

• Fixed rate and payments: Your rate and monthly payments don’t fluctuate.

• Predictable terms: The loan has defined repayment terms so you know exactly when it will be paid off.

• Upfront access to funds: You receive the full loan amount at closing. This works well if you need a set amount of money for a big expense like a home renovation.

The cons include:

• Less flexibility: You can’t draw more funds later if unexpected needs arise. You would need to take out another loan.

• Higher initial costs: Home equity loans often come with upfront closing costs.

• You start owing interest immediately: Interest accrues on the full loan amount as soon as you close.

What is a HELOC?

HELOC stands for Home Equity Line of Credit. As the name implies, a HELOC provides revolving access to funds up to a set credit limit. It works more like a credit card than a one-time loan.

With a HELOC, you go through an initial application process where the lender approves you for a maximum credit limit. For example, if you qualify for a $100,000 HELOC, you can access up to that amount over the next 10 years. You only pay interest on the amounts you actually withdraw.

HELOCs have a draw period (often 10 years) followed by a repayment period (typically 20 years). During the draw period you can access funds as needed. Repayment terms are flexible – you can pay back just the interest, or pay down the principal too.

After the draw period ends, no new funds can be accessed. You begin making principal and interest payments on the outstanding balance for the remainder of the repayment term.

Pros of HELOCs include:

• Flexibility to access funds as needed: Useful if you have ongoing or unexpected expenses.

• Only pay interest on what you use: Your costs are lower if you don’t max out the credit line.

• Typically lower rates than loans: HELOC rates are variable but often start lower.

Some potential cons are:

• Variable rates: Your interest rate and monthly payments can go up over time.

• Discipline is required: The credit line could encourage overspending.

• Closing costs and fees: You’ll pay origination fees to open the HELOC.

• Less predictable terms: Your payoff date depends on how much you borrow.

Key Differences Between HELOCs and Home Equity Loans

When deciding whether a home equity loan or HELOC is the better option, consider these key differences:

• Access to funds: HELOCs provide flexible access as needed; home equity loans offer a lump sum upfront.

• Interest rates: HELOCs have adjustable variable rates; home equity loans have fixed rates.

• Fees: Home equity loans often have higher upfront closing costs. HELOCs have lower origination fees but may charge annual maintenance fees.

• Payments: HELOCs offer flexibility in repaying principal; home equity loans have fixed monthly payments.

• Payoff timeline: Home equity loans have set repayment terms. HELOCs depend on your borrowing and repayment.

Below is a table summarizing some of the key features of each:

Who Should Consider a Home Equity Loan?

Home equity loans work well if you:

• Need a set amount of funds for a specific purpose like a home renovation
• Want predictable monthly payments that fit your budget
• Prefer a fixed interest rate and term length
• Don’t anticipate needing more funds later

Good uses for home equity loan funds include:

• Home improvements and renovations
• Paying off higher interest debt
• Major one-time expenses like tuition or medical bills

Who Should Consider a HELOC?

HELOCs are a better choice when you:

• Have ongoing or unexpected borrowing needs
• Want maximum flexibility in accessing funds and repayment
• Prefer to only pay interest on what you actually borrow
• Are comfortable with the risk of variable interest rates

Smart uses for HELOC funds include:

• Ongoing home improvement projects
• Supplementing irregular income
• Building an emergency fund
• Consolidating higher interest rate debts

Weighing the Pros and Cons

As you consider your options, think about your specific financial situation and plans for using the funds. Below are a few key questions to help weigh the pros and cons:

• How much money do you need to borrow? Is it a one-time need or ongoing?

• How quickly will you be able to repay the debt?

• What is your risk tolerance for variable interest rates and monthly payments?

• How long do you plan to stay in your home?

• Are flexible repayment terms or low initial costs more important?

• How much equity do you have available to borrow against?

There is no one-size-fits-all product. The right loan comes down to your unique needs and priorities. Evaluating both types side-by-side can provide valuable insight into the best option for your situation.

Next Steps to Choose the Right Loan

If you’re ready to move forward, here are some suggested next steps:

• Check your credit reports and scores so you can qualify for the best rates.
• Calculate your monthly debt obligations and home equity to estimate loan amounts.
• Get rate quotes from multiple lenders and compare total costs.
• Ask lenders to fully explain fees, terms, and the approval process.
• Read loan agreements carefully before signing anything.

Home equity loans and HELOCs can be cost-effective ways to tap into your home’s hard-earned equity. But make sure you understand all of the options as well as the risks before making a decision. With some careful research, you can determine which loan works best for your financial situation.