HELOC vs. home equity loan: How to make the right choice
A HELOC has a variable interest rate while a home equity loan has a fixed interest rate, but the differences don’t end there.
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Amy Fontinelle is a personal finance journalist with work featured in Forbes Advisor, The Motley Fool, Investopedia, International Business Times, MassMutual, and more.
Updated September 12, 2024, 3:11 PM EDT
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According to ICE Mortgage Monitor, the average mortgage holder has about $193,000 in tappable equity in their home, but if you’re looking to access yours, you might be wondering what’s the best option. Home equity loans and home equity lines of credit (HELOCs) both allow you to borrow money against the value of your home. One option might be better for you than the other depending on how you want to use the money, whether you need a lump sum or a line of credit, and how comfortable you are with risk. Learn about the pros and cons of each, including features, rates, and repayment terms, to help you make an informed decision.
How does a HELOC work?
A HELOC lets you borrow against the part of your home’s value that belongs to you, which is the principal you’ve paid toward your first mortgage plus any market appreciation above the purchase price. It’s a revolving line of credit that you can draw on as you need it, and if you repay principal during the draw period, you’ll replenish your credit line.
A HELOC’s interest rate is variable, which means it can change as often as monthly with market conditions. Your monthly payments can fluctuate and your loan repayment options may be more flexible in that some lenders allow you to make interest-only payments for the first few years of your HELOC term.
The draw period during which you can borrow against your line typically ends after no more than 10 years and is followed by a 20-year period where you repay both interest and principal. You’ll have to pledge your home as collateral, which means it’s essential to keep up with your payments so you don’t lose your home.
For example:
Many lenders let you borrow up to 80% of your home’s equity. Say your home is worth $400,000 and you owe $250,000 on your mortgage. The difference — $150,000 — is your equity. Multiply that by 0.80 to find the max amount you could borrow: $120,000.
How does a home equity loan work?
A home equity loan also lets homeowners borrow against the portion of their home’s market value that belongs to them. Unlike a HELOC, a home equity loan requires you to borrow a lump sum upfront, and you can’t get any more money after that. It’s a closed-end loan with a single disbursement.
Also unlike a HELOC, the interest rate on a home equity loan is fixed and payments are fully amortized from the beginning. Each monthly payment is the same for the life of the loan.
Note:
Just like your first mortgage, more of your payment goes toward paying interest and less goes toward principal at the beginning of your loan term. That balance gradually shifts so that your last payment is almost entirely principal.
Home equity terms can be five to 30 years, and your home is the collateral for the loan. If you default on your payments, you risk losing your home.
Factors that affect home equity loan and HELOC rates
Both individual and external factors determine the rate you’ll get when you borrow against your home equity.
Personal factors
Before you apply for a home equity loan or HELOC, see where you stand on these personal factors and try to improve them if possible:
- Credit score: You’ll need a credit score of at least 620 to 660, depending on the lender and market conditions, to get a home equity loan or HELOC. To get a lender’s best rate, you may need a score of 780 or higher. Having a higher credit score can also give you access to more of your equity.
- Credit history: A track record of on-time payments — especially when it comes to your mortgage — is key. Payments that are more than 30 days late may show up on your credit report and are a warning signal to lenders that can get you rejected or lead to a higher interest rate.
- Debt-to-income ratio: While some home equity lenders may approve your application with a DTI ratio as high as 50%, you may have more options if your DTI is 43% or less. The best rates may require that your DTI is below 43% or even as low as 36%.
- Credit line or loan size: Borrowing less of your equity can help you get a lower rate. You’re less likely to default on your loan when you stand to lose a lot of your own investment. That said, some lenders offer lower rates when you borrow more.
- Loan term: With a shorter loan term, you may qualify for a lower interest rate and be able to borrow more.
- Occupancy: Loans secured by the home you live in will usually cost less than loans secured by a second home or investment property.
- Lien position: If you have no other mortgages, your home equity lender will be in first lien position, meaning they would be first in line to get repaid if you default on your loan. You may pay a slightly lower rate if you’ll have a first-lien home equity loan.
- Banking relationship: If you have a checking account with the same company, you may get a small discount, such as 0.25 percentage points, for having your loan payments automatically deducted from that account.
Economic factors
Whether you’re considering home equity financing, knowing what’s going on with the economy can help you understand what’s going on with interest rates. If you’re not in a hurry to borrow, you might be able to apply or lock your rate when circumstances are more favorable. Interest rates are based on similar factors as those affecting other types of loans:
- Inflation: When the annual inflation rate is higher than 2%, the Federal Reserve tries to slow down spending and reduce inflation by raising interest rates. When inflation falls below the 2% target, the Fed decreases interest rates to encourage households and businesses to borrow and spend more.
- Unemployment: Inflation can coincide with low unemployment. When the unemployment rate is low, workers can demand higher pay, which can cause prices to climb and increase inflation.
- Global events: Americans feel the impact of global events in many ways, and one of those is interest rates. Extreme weather, communicable disease, war, and other turmoil can make it more difficult to get natural resources, goods, and labor. This scarcity can increase inflation and impact the cost to borrow money.
- Loan demand: When lots of consumers want home equity loans, lenders can become overwhelmed. If they can’t handle the additional demand at a profitable price or don’t have enough credit to offer borrowers, they may charge higher rates.
- Property state: Lenders may charge higher rates in some states than others because of state laws and factors that affect their cost of doing business there.
While you don’t have any control over these factors, you might feel better understanding what influences your rate if you’re looking into getting a home equity loan or HELOC. You can also keep an eye on larger economic events and mortgage rate trends to decide if it’s a good time to borrow against your home’s equity.
HELOCs vs. home equity loans
A major benefit that both of these loans options have is that you can use the proceeds for any purpose. Some popular uses are home improvements, debt consolidation, and higher education since using your real estate as collateral can give you a lower interest rate than a credit card or personal loan.
The other factors are more subjective. To decide which borrowing option is best for your goals, you’ll want to know about the key differences between these two equity borrowing choices:
HELOC vs. home equity loan FAQ
Is a HELOC or a home equity loan better for long-term financing?
A home equity loan may be a better choice for long-term financing since the interest rate and monthly payment are fixed. Many borrowers appreciate the predictability and stability of these features.
How does a HELOC affect home selling?
A HELOC will not prevent you from selling your home unless your home loses value to the point where the proceeds from the sale, after closing costs, are not enough to pay off your mortgage debt. In that situation, you might still be able to sell your home if you can make up the difference from your savings account or the sale of another asset.
Can HELOC or home equity loan interest be tax deductible?
Yes, HELOC or home equity loan interest can be tax deductible if you use the money to buy, build, or substantially improve your main home. Also, you can only deduct interest on home loan debt up to a certain amount depending on your tax filing status and when you took out the loan.