HELOC vs. Home Equity Loan: Pros and Cons
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Home equity loans and home equity lines of credit (HELOCs) are loans that allow you to convert some of your home’s equity into cash. These loans have similar benefits — for example, both HELOCs and home equity loans have relatively low interest rates because they’re backed by your home. They’re also both second mortgages that don’t affect your primary mortgage rate. However, they also have key differences that make each loan suited to different borrowers.
Weighing the pros and cons of each will help you decide which is right for you.
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What is home equity?
Home equity is the present value of your home, minus what you owe on your mortgage. This represents the percentage of your home that is owned by you versus the portion that’s owned by your lender. You can’t access the share owned by the lender, but you can convert some of your equity back into debt in exchange for cash.
Depending on your financial track record, lenders may let you borrow up to 80% to 85% or more of your home equity. Keep in mind, though, that you’re using your home for collateral, so the lender can foreclose on that property if you default on payments.
The amount you owe on all home loans divided by the market value of your home is considered the combined loan-to-value ratio. If that ratio is high, lenders will hesitate to let you borrow more against the home’s value.
For example, your home is worth $300,000, and you owe $150,000. Dividing 150,000 by 300,000 is 0.50, which means you have a 50% loan-to-value ratio. A lender that allows a combined loan-to-value ratio of 80% may approve a home equity loan or line of credit for $90,000, or 30% of the home’s value.
What is a home equity loan?
Home equity loans are second mortgages that typically have fixed interest rates, meaning the payment is the same each month. A home equity loan payment would be in addition to your usual mortgage payment.
You receive the loan at one time as a lump sum. A home equity loan can be a good source of funds for a home improvement project with a defined cost and one-time expenses such as debt consolidation.
Home equity loan pros
Interest rate is fixed.
Monthly payments won't change for a set period.
Home equity loan cons
You immediately start making payments on both principal and interest.
You have to know exactly how much you’ll need, and borrowing more money will require taking out another loan.
What is a HELOC?
HELOCs and home equity loans are similar in that you’re borrowing against your home equity. But a home equity loan typically gives you a sum of money at once, while a HELOC is similar to a credit card. You’ll usually have 10 years to draw from the line of credit, during which time you only have to pay interest on the amount borrowed. After that, you can’t borrow anymore, and you’ll have to pay both principal and interest.
HELOCs often begin with a lower interest rate than home equity loans; however, the rate is variable, which means it rises or falls according to a base rate called the prime rate.
Current prime rate | Prime rate last week | Prime rate in the past year — low | Prime rate in the past year — high |
|---|---|---|---|
8.50%. | 8.50%. | 8.0%. | 8.50%. |
That means your monthly payment can rise or fall, too.
Some lenders will let borrowers carve out a portion of what they owe on a HELOC and convert it to a fixed rate. You’ll still have the balance of your line of credit to draw from at a variable rate.
» MORE: Compare the best HELOC lenders
HELOC pros
Pay interest compounded only on the amount you draw, not the total equity available in your credit line.
You can continue to draw from the line as needed, which means you don’t need to know exactly how much you’ll need upfront.
HELOC cons
Rising interest rates can increase your payment.
Your minimum monthly payments will increase during the repayment period once the principal is factored into the cost.
Differences between HELOCs and home equity loans
Features of the loan | HELOC | Home equity loan |
|---|---|---|
Loan funding | Borrowers can draw funds as needed, up to a certain limit (typically a percentage of their equity). | Borrowers receive a lump sum at closing (typically a percentage of their equity). |
Terms | Begins with a draw period (typically 10 years) with interest-only minimum payments, followed by a repayment period (often up to 20 years) that requires borrowers to pay back principal and interest. | Repayment periods are often up to 30 years. Minimum payments include both interest and principal. |
Rates | Variable, though some lenders offer a fixed-rate option. | Fixed. |
Borrowing limits | Borrowers can typically borrow between 80% and 85% of their equity in their home, though some lenders allow for more. Use NerdWallet's HELOC calculator for personalized details. | Borrowers can typically borrow between 80% and 85% of their equity in their home, though some lenders allow for more. Use NerdWallet’s home equity loan calculator for personalized details. |
Lenders |
Requirements for a HELOC or home equity loan
Despite their differences, HELOCs and home equity loans tend to have the same requirements. These include:
Equity of at least 15% to 20%. This means that your remaining mortgage balance can’t equal more than 80% to 85% of the value of your home.
A debt-to-income ratio below 50%. This means that all of your monthly debt obligations must be less than 50% of your income. The lower this number is, the more likely you are to qualify with the widest range of lenders. Lower amounts of debt can also lead to lower rate offers.
A credit score of 620 or higher. This is the minimum credit score allowed by most lenders, though a higher score will help your chances of getting approved and can yield lower rate offers.
A reliable credit history. Lenders will want to see that you have a solid track record of paying your bills on time.
Should I get a HELOC or home equity loan?
Before deciding whether to apply for a HELOC or a home equity loan, consider how much money you need and how you plan to use it. Factor in interest rates, fees and monthly payments as you weigh your options.
Accessing the equity in your home before selling can be a powerful financial benefit. But remember, you're using your home as collateral. Whether you choose a home equity line of credit or a loan, resist funding short-term needs with what may eventually amount to a long-term loan.
Terms and characteristics of home equity loans and lines of credit vary from one lender to another. Be sure you understand the costs and repayment schedule of a loan before you commit to a lender, and shop around before you sign on the dotted line.
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