Some long-time homeowners who need cash for big expenses may decide to tap into their equity through a HELOC (home equity line of credit) or a home equity loan. Maybe you need to consolidate high-interest credit card debt, pay for emergency repairs, or fund your child’s education. Home equity is often a better option to finance these things than other loan options, but how do you pick between a HELOC and a home equity loan?
While both a HELOC and a home equity loan allow you to borrow against your property, they are two different tools for different situations. Here’s what you need to know when choosing between the two, their key differences, and how to determine which is right for your financial goals.
What’s the difference between a HELOC and a home equity loan?
The biggest difference between the two is how you receive and repay the money. A home equity loan is an installment loan where you get a one-time lump sum and pay it back in installments over a set term.
A HELOC (home equity line of credit) is a revolving credit line. Similar to a credit card, you can borrow and pay back money as needed up to a specific limit during the “draw period.”
| Home equity loan | HELOC | |
|---|---|---|
| Structure | Lump sum payment | Credit line |
| Interest rate | Typically fixed | Typically adjustable |
| Monthly payment | Predictable, fixed amounts | Fluctuates with balance and rates |
| Structure | Fixed repayment (e.g., 15 years) | A draw period with interest-only payments, followed by a repayment period |
| Best for | On-time, large expenses | Ongoing projects or emergencies |
HELOC vs. home equity loan: Real-life example
To see how this works in practice, let’s compare two ways of tapping into $50,000 of equity:
- Home equity loan: You receive the full $50,000 upfront at an 8% fixed rate for 15 years. Your monthly payment is approximately $478(covering both interest and principal), and you know exactly what you owe each month until the loan is paid off.
- HELOC: While approved for $50,000, you only spent $30,000 on your renovations. During the draw period at a 7.5% variable rate, you might only pay $187.50 per month in interest. Once the repayment phase kicks in, your payment could jump to $242, as you begin paying back the principal. If the Federal Reserve raises interest rates, your HELOC payment will rise accordingly. With a HELOC, you trade a lower initial payment for the risk of future rate volatility.
Note: Keep in mind that these monthly payments will be in addition to your existing mortgage payments, not a replacement for them.
HELOC vs. home equity loan: Qualifying requirements
Generally, there’s not much difference when it comes to qualifying for a HELOC versus a home equity loan.
Both HELOC and home equity loans are considered “second mortgages” by lenders. Because the primary lender is paid first in the event of a foreclosure, both HELOCs and home equity loans have stricter standards than traditional mortgages.
- Credit score expectations: Typically, you need a credit score of 660 or higher for either. While some lenders accept scores in the low 600s, a higher score significantly increases your chances of securing favorable terms and lower rates.
- Debt-to-income ratio: Lenders prefer your total monthly debt payments (including the new loan) to be below 43-50% of your monthly gross income.
- Loan-to-value (LTV) limits: Usually, you can borrow up to 80-85% of your home’s appraised value for either a HELOC or home equity loan. According to Bernie Frascarelli, executive loan officer at Best Interest Financial, a lender may not even require a formal appraisal and can estimate value based on the comps and publicly available information.
For both products, lenders will look for income stability and evaluate your ability to make regular payments. However, for a HELOC, they may focus more heavily on your ability to handle the payments if the variable rate fluctuates significantly in the future.
HELOC vs. home equity loan: interest rates and repayment
This is where the two differ significantly. If you are trying to decide which option is best for you, make sure you understand the long-term repayment structure for both.
Fixed vs. variable rates
Home equity loans almost always offer fixed rates from day one. This provides borrowers with peace of mind, knowing that monthly payments will stay unchanged regardless of market shifts.
In contrast, a HELOC typically comes with a variable rate based on the Prime Rate. The Prime Rate is heavily dependent on the Federal Funds Rate, so depending on its fluctuations, your payment can change monthly.
To illustrate how significant these fluctuations can be, in the last ten years, HELOC rates have ranged from 3.86% at the lowest to 10.16% at their highest.
Repayment structure
A home equity loan is amortized from day one. This means every payment covers some interest and some principal. HELOCs are more complicated and depend on your lender and the terms of your loan.
Usually, all HELOCs have two phases: a draw period and a repayment period.
- The draw period usually lasts for the first 5-10 years. During this period, you can take money out up to your credit limit. Many HELOCs allow interest-only payments during the draw period, though some require paying off a portion of the principal as well.
- The repayment period comes after, lasting the next 10–15 years. At this phase, you can no longer borrow funds and must repay your balance. This is where some borrowers can experience payment shock, as the monthly bill jumps from interest-only to a much higher interest-and-principal payment.
❗Beware of balloon payments: Some HELOCs might have a clause where a borrower needs to repay their debt in full at the end of the draw period. If you don’t have the cash to cover this balloon payment, you may be forced to refinance the debt or sell the home to cover the balance. Always check with your loan officer about what the repayment terms are.
How to decide which one is better for you
It all comes down to your personal goals, your risk tolerance, and the current market situation. Here are some pointers to ask yourself when deciding between a HELOC and a home equity loan.
- How do you plan to use the money? If it’s a fixed, one-time expense (like $20,000 in emergency repairs), a home equity loan is likely the better choice. If you don’t need all the money immediately or want to have an ongoing emergency fund, a HELOC may suit you better, since you don’t have to pay interest on money you haven’t used yet.
- Do you know how much you need to borrow? If you have ongoing projects or want the option to pull out more money when needed, a HELOC provides this flexibility.
- Are you risk-tolerant? If you are comfortable with the possibility that your monthly payments can change significantly and don’t mind the gamble in exchange for lower initial payments, consider a HELOC. For those who need budgetary certainty, a home equity loan may be safer.
- How fast can you pay the money back? If you plan to pay off the debt quickly (within 1–3 years), a HELOC is often the winner. You can aggressively pay down the principal and then access the credit line again when another need arises.
- Do you have the discipline for a line of credit? A HELOC has the feel of a credit card with a high credit limit: you can finance multiple expenses now and pay later. For some, it may be tempting to max it out for unplanned lifestyle purchases, like a vacation or a new car. If you worry about your self-discipline, a home equity loan may be a safer option.
Risks to be aware of before borrowing against your home
Borrowing against your home is inherently risky because the propertyserves as collateral. If you fail to repay the loan, the lender can foreclose. Make sure you are fully aware of the consequences if you don’t make the payments before committing to either option.
| HELOC risks | Home equity loan risks |
|---|---|
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Additionally, keep in mind that some lenders may charge prepayment penalties if you sell your home or refinance in the first few years after securing the loan.
Finally, when shopping for a HELOC or home equity loan, choose your lender wisely. Be aware of predatory practices, for example, when a lender pressures you into signing a new loan or those who don’t mention balloon payments and hide behind the fine print. If you feel you were treated unfairly, you can report fraud to one of these government agencies.
Talk to a loan officer to get the full picture on your options
One of the biggest mistakes you can make is taking the first offer you see. Rates and terms may vary wildly between different lenders, so make sure you compare multiple options and 100% understand the product you choose.
Since Best Interest Financial is a mortgage broker, we can help you compare multiple HELOC and home equity loan options at once and find creative solutions that big-box banks miss. Start with a 60-second quote to see how to use your home equity to your advantage.
FAQ about HELOCs and home equity loans
Is a HELOC or home equity loan a good option if I’m having trouble paying my mortgage?
No, it’s generally not a good option to take on more debt when you are struggling with your mortgage payments. Remember that you would have to continue paying your mortgage and make new loan payments on top of that. Instead, call the CFPB at (855) 411-2372 to be connected to a HUD-approved housing counseling agency or explore more options for those struggling to make mortgage payments.
How is a $50,000 home equity loan different from a $50,000 HELOC?
With a $50,000 home equity loan, you receive the full amount immediately and start repaying it. With the HELOC, you have a $50,000 borrowing limit. If you use only $3,000 of it, you only have to repay that amount plus interest.
Is a HELOC a trap?
Whether or not a HELOC is a trap for you depends on how you use it and how prepared you are to pay it back. It can end up being a trap if you are unaware of variable interest rates or balloon payments, or if your home's value significantly decreases.
What does Dave Ramsey say about a HELOC?
Generally, Dave Ramsey advises against HELOCs because they put your home at risk, do not help lower your debt, and can lead to financial issues.
What is the smartest thing to do with a HELOC?
The smartest thing you can do with a HELOC is use it as a backup emergency fund or use it for home improvements that significantly increase the property’s value.
Do wealthy people use HELOCs?
Yes, wealthy people use HELOCs all the time. As Bernie Frascarelli, executive loan officer at Best Interest Financial noted, some investors may use HELOCs as liquidity tools to provide the cash needed to purchase investment properties. Although he doesn’t advise this, Frascarelli noted that he’s even seen wealthy people use HELOCs for down payments on yachts.
Disclaimer: The information provided in this article is for informational and educational purposes only. It is not intended as legal, financial, investment, or tax advice, and should not be relied upon as such. Mortgage rates, terms, products, and eligibility requirements are subject to change without notice and vary based on individual circumstances, credit profile, property type, loan amount, and other factors. All loans are subject to credit approval. This content does not constitute a commitment to lend or an offer of specific loan terms. For personalized mortgage advice and to discuss loan products that may be suitable for your situation, please contact one of our licensed loan officers.