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A home equity loan lets you convert some of your equity back into debt in exchange for a lump sum of cash, which you pay back at a fixed interest rate. Home equity lines of credit, or HELOCs, are similar products with two key differences: the interest rate is often variable, and instead of a lump sum, you have a credit limit. You can draw up to that limit, pay it down, and borrow again as you need it.
Both HELOCs and home equity loans have lower interest rates than personal loans or credit cards because they’re backed by your home. They’re also both second mortgages that don’t affect your primary mortgage rate.
Home equity loans can be a solid choice if you know exactly how much you need to borrow and can start paying towards the principal right away. HELOCs are often a better choice for borrowers who need flexibility.
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Key differences between HELOCs and home equity loans
- Interest rates: HELOCs typically have a variable interest rate; home equity loans have a fixed rate.
- Access to funds: HELOCs allow you to borrow as needed up to your credit limit; home equity loans give you a lump sum.
- Minimum monthly payments: HELOCs usually only require interest payments during the 10-year draw period; home equity loans require you to pay interest and principal from the beginning.
- Benefits and drawbacks: Both loans typically have higher interest rates than primary mortgages, but lower rates than personal loans or credit cards. Since both kinds of second mortgages are backed by your home, they also both carry similar risks of foreclosure if you can’t keep up with the monthly payments.
- Who it’s for: Home equity loans can be a better choice if you know exactly how much you’ll need to borrow, while HELOCs are better suited to borrowers who want to borrow flexibly.
What is home equity?
Home equity is the value of your home, minus what you owe on your mortgage. For instance, if your home is worth $400,000 and you owe $150,000 on your mortgage, you have $250,000 in home equity.
Many lenders won’t let you borrow more than 85% of the value of your home. In the example above, you’d need to hold onto at least $60,000 of home equity.This would give you a maximum borrowing limit of $190,000.
Keep in mind that you’re using your home for collateral, so the lender can foreclose if you default on payments.
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%. This means that your remaining mortgage balance can’t equal more than 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, though 43% or less is preferred. 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 640-680 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.
Home equity loans: pros and cons
Home equity loans are second mortgages that typically have fixed interest rates, and your payments will include both interest and principal. You usually have up to 30 years to repay the loan.
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.
Pros
- Interest rate is fixed.
- Monthly payments will be the same every month for the life of the 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.
HELOCs: pros and cons
HELOCs work somewhat like a credit card. You’ll usually have 10 years to draw from the line of credit, with a limit based on your home equity.
During the draw period, you’re usually only required to pay interest on the amount borrowed. After those 10 years are up, you can’t borrow any more, and you’ll begin repaying both principal and interest — often over a 20-year repayment period.
Pros
- You only pay interest on the amount you draw, not the full credit line.
- You can borrow as needed, so you don’t have to know the exact amount you’ll need up front.
Cons
- Interest rates are variable. If they go up, so will your monthly payments.
- Your minimum monthly payments will increase during the repayment period when you have to pay down the principal balance.
HELOCs often begin with a lower introductory rate; however, the rate is variable, which means it rises or falls according to the market. That means your monthly payment can rise or fall, too.
If you’re wary of the risks that come with a variable rate, you can narrow your search to lenders that offer a fixed rate option. You’ll still have the balance of your line of credit to draw from at a variable rate.
Differences between HELOCs and home equity loans
| Features of the loan | HELOC | Home equity loan |
|---|---|---|
| Loan funding | You can draw funds as needed, up to a certain limit (typically a percentage of your equity). | You receive a lump sum at closing (typically a percentage of your equity). |
| Terms | Begins with a draw period (typically 10 years) with interest-only minimum payments. This is followed by a repayment period (often up to 20 years) that requires you 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 | You can typically borrow around 85% of the equity in your home. Some lenders allow for more. Use NerdWallet's HELOC calculator for personalized details. | You can typically borrow around 85% of the equity in your home. Some lenders allow for more. Use NerdWallet’s home equity loan calculator for personalized details. |
| Lenders |
Should you 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.
Terms and features 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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