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If you’re considering getting a loan using the equity in your home, you’re going to see the phrases “home equity loan” and “home equity line of credit” (or HELOC), almost everywhere you look.
Both can be used to fund large expenses, such as home renovations, which can increase the value of your home in the long run.
Both are available from lenders including traditional banks, credit unions, and online lenders. And both are secured, or guaranteed, by the same asset — your home. That means the lender could foreclose on it in the event you do not repay.
While home loans and lines of credit are somewhat similar, there are key differences that make one or the other preferable in a given situation.
|Home Equity Loan||Home Equity Line of Credit|
|Duration||Up to 30 years||Typically 25 years|
|Paid to you as||Lump sum||Revolving credit|
|Costs||Up to 5% of loan amount||Various recurring fees|
|Tax deductible interest||Yes||Yes|
What Is a Home Equity Loan?
A home equity loan is a loan against the value of your home, paid to you in a lump sum. That makes it an attractive option for large, one-time expenses, such as getting a new roof or funding a large-scale home renovation.
A homeowner can “borrow money from a bank and the equity in their home serves as collateral to the loan,” Elliott Pepper, a Certified Financial Planner and co-founder of Northbrook Financial, explained in a previous NextAdvisor article.
Home equity is the current value of your home minus what you still owe on your mortgage. If your house is valued at $400,000 and you have $100,000 left on your mortgage, you have $300,000 in home equity.
The more equity you have in your home, the more you’ll be able to borrow, typically up to 85% of that equity. The total amount will be influenced by other factors as well, such as how much other debt you have and what your credit score is.
You will have to repay the loan over a predetermined period of time, similarly to how you pay off your mortgage: each month, and in fixed installments.
If you choose a home equity line of credit, make sure it does not have penalties for prepayment.
Most home equity loans have five- to 30-year terms and fixed interest rates. The average interest rate on a home equity loan is currently below 6%, according to Bankrate, which shares an owner with NextAdvisor. Be sure, however, to base your calculations on the annual percentage rate (APR), which represents what you will actually pay, rather than the interest rate.
Interest on home equity loans, and on HELOCs as well, is tax deductible if the funds are used to substantially improve your home and total debt related to the house — including all other mortgages and/or home equity loans — does not exceed $750,000.
Home equity loans come with costs and fees similar to a standard mortgage’s. Those costs range in general from 2% to 5% of the loan amount; it’s possible to get the lender to waive some of the fees, Pepper says. It’s worth asking, especially as lenders are cognizant that many people are going through financial hardship as a consequence of the coronavirus pandemic.
The best place to start your search for a home equity loan is your bank; some banks might even require having an account with them to get a home equity loan. Working with a bank where you are an account holder might also result in a lower interest rate.
What Is a Home Equity Line of Credit?
With a home equity line of credit, or HELOC, you are given credit up to a predefined maximum amount, similar to how a credit card works. You can tap into that credit for expenses such as home renovations, or to consolidate higher-interest debt. Because the credit line remains available for a long time — a typical term is 25 years — it’s a good way to fund ongoing home projects; it can also be a source of funding for future needs as they may arise.
Quite simply, “a HELOC is a revolving line of credit secured against the value of the equity in your home,” says Lindsay Martinez, a Certified Financial Planner at financial planning firm Xennial Planning.
HELOC interest rates are usually much lower than on credit cards, making them an option for people who have high credit card debt and are looking for ways to save on interest payments. (Another way to consolidate debt is to do a balance transfer to a credit card offering an introductory period with zero interest on balance transfers.)
Like with a credit card, which is also a revolving line of credit, you can tap into a HELOC for what you need at a given moment. Let’s say you have a HELOC of $50,000 and want to renovate your kitchen, which will cost you $20,000. You can take the $20,000 out of that home equity line of credit, and repay it in regular installments. The other $30,000 will remain available.
And, just like with a credit card, you cannot go above the credit limit. You also do not have to use all of it, and you can pay off the balance you owe at any time before the HELOC term ends. You also cannot deduct interest on a HELOC if you use the funds for anything other than home improvements, like paying credit card debt.
The size of the line of credit will also be affected by the size of the equity in your home; the more equity you have, the bigger the line of credit can be. Your credit score and employment situation also come into consideration.
“Similar to any home-related loan, there will typically be fees incurred when the HELOC is opened,” says Pepper; those are comparable to the closing costs on a mortgage. These fees can include origination fees, notary fees, title fees, recording fees to the local government, and appraisal fees.
A HELOC may also come with ongoing fees, which could include any or all of the following:
- Annual fee, charged every year whether or not you use the credit. This can also be known as a membership or maintenance fee;
- Inactivity fee, charged if you do not use the line of credit for a period of time;
- Early termination fee, charged if you close your HELOC before the term is up;
- Minimum withdrawal, which could lead to unwanted interest costs if you don’t need the money right away, Pepper says.
It is possible to have at least some or all of those fees waived if your lender charges them; it never hurts to ask.
HELOC terms are also divided into two periods: a draw period and a repayment period. For example, a 25-year line of credit might have a draw period of five to 10 years and a repayment period of 10 to 20 years.
The draw period is the time during which you can tap into the credit line; the only payments you’ll have to make during this period are interest due on the amount that you’ve drawn.
After that, the “repayment period” begins, when you will be paying back principal plus interest. Most HELOCs have variable interest rates.
“When the draw period concludes, the debt outstanding is amortized subject to the terms of the loan,” says Yusuf Abugideiri, a senior financial planner at Yeske Buie. Amortization simply means that, as a loan ages, more of your payment goes towards the principal and less toward interest. You can also make extra payments towards reducing the principal during the draw period.
Note that you cannot sell a home while a HELOC is open, since it acts as a lien against the property.
Home equity loans and home equity lines of credit can be used for similar goals, but have significant differences. While the former is effectively a second mortgage on your home, the latter is a revolving line of credit; you can think of it as a low-interest credit card guaranteed by the value of your home.
Once you know what you want to use the funds for, you will be able to make an informed choice between the two.