HELOC vs. Home Equity Loan: Which Way to Tap Your Equity

A home equity loan gives you one lump sum that you repay on a set schedule, while a home equity line of credit (HELOC) works more like a credit card secured by your home: you draw what you need, repay it, and can draw again. If you already have a mortgage, either one sits behind it as a second mortgage. The right choice usually comes down to whether you know exactly how much you need, and how much payment change you can live with.

What both loans have in common

Both products let you borrow against your home equity, which is the difference between what your home is worth and what you still owe on it. Both use your home as collateral. That is why they often come with lower rates than unsecured debt, and it is also the biggest risk: if you cannot keep up with payments, you could lose your home.

If you already have a first mortgage, the new loan becomes a second mortgage. You keep paying your original mortgage as before and add a separate payment for the new loan. Your first mortgage terms do not change.

Both also involve an application, a review of your credit and income, and usually a home valuation. Approval and terms are subject to credit approval and vary by borrower, property and lender.

How a home equity loan works

A home equity loan is a closed-end loan. You borrow a set amount, receive it all at closing, and repay it in regular installments over the life of the loan. Once you receive the money, you cannot borrow more from the same loan.

The rate on a home equity loan may be fixed or adjustable, depending on the loan you choose. Many borrowers pick a home equity loan when they want predictable payments and a clear payoff path.

A home equity loan tends to fit situations like these:

• You have a single, known expense, such as a specific renovation with a firm contractor bid.
• You want to consolidate a defined set of debts into one payment.
• You prefer knowing what you owe each month and when the loan will be paid off.

The tradeoff is flexibility. You start paying interest on the full amount right away, even if you do not spend it all at once. If your project costs more than expected, you would need to apply for additional financing.

How a HELOC works

A HELOC is an open-end line of credit. The lender approves a maximum credit limit, and you can draw against it as needed, often by transfer, special checks or a card. As you repay what you borrowed, that amount becomes available to borrow again.

Most HELOCs have two phases:

• The draw period. You can borrow up to your limit. Depending on the plan, required payments may cover only interest or include some principal. Some plans require a minimum draw or an initial withdrawal.
• The repayment period. Once the draw period ends, you can no longer borrow, and you repay the balance. Some plans repay over a set schedule. Others require the remaining balance in one large balloon payment. If you could not pay a balloon payment through refinancing or another source, you could lose your home.

Most HELOCs have variable rates. The rate is made up of an index, which is a public benchmark that moves with the broader economy, plus a margin the lender adds. When the index changes, your rate and payment can change, even if you do not borrow another dollar. Some plans offer a temporary introductory rate, and some let you convert part of the balance to a fixed rate.

Side-by-side differences

Here is how the two compare on the points that matter most to most borrowers:

• How you get the money. Home equity loan: all at once. HELOC: as needed, up to a limit.
• Rate type. Home equity loan: fixed or adjustable. HELOC: usually variable, sometimes with a fixed-rate conversion option.
• Payments. Home equity loan: regular installments from the start. HELOC: payments depend on what you have drawn and on rate changes, and may rise when the repayment period begins.
• Interest. Home equity loan: charged on the full amount from day one. HELOC: charged only on what you have drawn.
• Reuse. Home equity loan: no. HELOC: yes, during the draw period.

Costs and fees to ask about

Both loans can carry upfront costs, such as an appraisal fee, an application fee that may not be refundable, and other closing costs. HELOCs can also have ongoing or exit costs, including annual fees, inactivity fees, transaction fees and early termination or prepayment fees. Lenders must disclose these terms, so ask for them in writing and compare offers side by side.

When you compare HELOC offers, look at more than the starting rate. Ask about the index and margin, how often the rate adjusts, whether there are rate caps or floors, the length of the draw and repayment periods, and whether the plan can end in a balloon payment.

Risks that apply to both

Borrowing against your home turns other spending into debt secured by the place you live. Keep these risks in mind:

• Foreclosure risk. Missing payments on either loan can lead to losing your home.
• Debt does not disappear. Using equity to pay off credit cards moves that debt onto your home. Stretching short-term debt over a longer period can cost more in total.
• Less equity later. Borrowing now leaves less equity to draw on if home values fall or you need to sell.
• Selling the home. When you sell, you generally need to pay off the second mortgage in full.

HELOCs carry one more risk: the lender can freeze or reduce your line if your home value drops significantly or your financial situation weakens. If that happens, you can ask why, check your credit reports for errors, or request a new appraisal.

How to decide which fits you

Start with how you plan to use the money. A known, one-time cost often points to a home equity loan. Ongoing or uncertain costs, such as a renovation done in phases or a cushion for irregular expenses, often point to a HELOC.

Next, think about payment comfort. If a rising payment would strain your budget, a fixed-rate home equity loan may feel safer. If you can absorb some movement and want flexibility, a HELOC may fit. Ask yourself whether you could still make payments if rates went up or your income dropped.

Finally, compare the whole picture. Other options may cost less or carry less risk depending on your situation, including a cash-out refinance, a personal loan or a personal line of credit that does not use your home as collateral. If you are struggling with your current mortgage, talk to a HUD-approved housing counselor before borrowing more against your home.

Your right to cancel

For many home equity loans and HELOCs on your principal residence, federal law gives you a short window after closing to cancel the transaction for any reason. You must notify the lender in writing. If you cancel, the lender must cancel the loan and refund the fees you paid. Your loan documents will explain how this works for your loan.

Next steps

Before you apply, gather recent pay stubs or income records, your most recent mortgage statement, homeowners insurance information and a list of what you plan to use the money for. Request written terms from more than one lender, compare the full cost and the payment structure, and choose the product that fits both your plans and your comfort with risk.

Frequently asked questions

Next steps

• HELOC
• Home Equity Loans

Sources

• CFPB: What is the difference between a home equity loan and a HELOC?
• CFPB: What you should know about home equity lines of credit
• CFPB: What other types of loans are similar to a HELOC?
• CFPB: What is a second mortgage loan or junior lien?