Summary
Choosing between a home equity loan and a home equity line of credit (HELOC) depends on your specific needs and risk tolerance.
- A Home Equity Loan (HEL) is when a lender provides a lump sum loan amount to a homeowner (at a specific interest rate and repayment term) in exchange for the homeowner using their house as collateral to guarantee repayment of the amount borrowed.
- A Home Equity Line of Credit (HELOC) is when a lender extends a credit line to a homeowner and uses their house as collateral to guarantee the repayment of any amount borrowed. As they repay the line of credit, they can re-access that line, typically for up to ten years (sometimes the draw period is less than five years).
- When comparing whether a HEL or HELOC is good for you, consider the purpose and use of the funds, the risk that interest rates will fluctuate, the pre-payment penalties, and the fees.
Making smart financial decisions is a key ingredient to long-term wealth. When it comes to your home, that has never been truer. As a homeowner, you have many options for accessing your equity to increase your long-term wealth; however, you may need more information and tools to determine the best path.
In this article, I’ll dive into the Home Equity Loan vs. Home Equity Line of Credit debate with valuable information and tools to help you decide which option will best help you meet your long-term financial goal of building wealth.
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House Numbers helps you access your home equity to pay off debt, fund home improvement, or general expenses.
| Home Equity Loan | Home Equity Line of Credit | |
|---|---|---|
| Also known as | Second mortgage | Revolving line of credit |
| Interest rate | Fixed | Variable |
| Monthly payment | Fixed for length of loan | Changes based on interest rates & amount you are currently borrowing |
| Funds | One time lump sum payment | Funds get drawn down as you need them |
| Existing mortgage | This is a second mortgage | You don’t need an existing mortgage |
| Term length | 10 to 30 years, depending on needs | Usually 30 years |
Let’s define home equity loan and home equity line of credit
Before comparing and contrasting a Home Equity Loan (HEL) and a Home Equity Line of Credit (HELOC), we must clearly define each debt obligation. After that, we can compare the two to see which option is better depending on specific circumstances.
What is a home equity loan?
A Home Equity Loan is when a lender provides a lump sum loan amount to a homeowner (at a specific interest rate and repayment term) in exchange for the homeowner using their house as collateral to guarantee repayment of the amount borrowed. Homeowners are generally free to do what they want with their home equity loans, including doing home improvement projects or paying off consumer debt.
HEL are called “second mortgages” since they go behind a first mortgage.
Quick facts about home equity loans
Here are some quick facts about a Home Equity Loan.
- They have the following repayment terms: 10-, 15-, 20- and 30-year repayment terms.
- HEL’s have fixed interest rates that never change.
- Most don’t have a pre-payment penalty, but some do.
- The monthly payment you make includes principal and interest.
- Typically, there are closing costs on a home equity loan.
The most common source to obtain a HEL is with a mortgage lender who also provides first mortgages.
What is a home equity line of credit?
A Home Equity Line of Credit is when a lender extends a credit line to a homeowner. That homeowner uses their house as collateral to guarantee the repayment of any amount borrowed. Over time, the homeowner can then access that credit line as needed.
As they repay the line of credit, they can re-access that line, typically for up to ten years (sometimes the draw period is less than five years). When homeowners access their line of credit, they can use it to pay off consumer debt, home improvement projects, and more.
Like a Home Equity Loan, a HELOC is usually in second position behind a first mortgage, but only sometimes. Many homeowners have a HELOC but don’t have a first mortgage.
Even though a HELOC is usually in second position behind a first mortgage, it’s incorrect to refer to a HELOC as a “second mortgage”. The reason is that it’s not a mortgage, and it’s like a credit card regarding how the homeowner can access their available funds.
As I mentioned, not all HELOCs are in second position behind a 1st mortgage. A bank or credit union is your most common source to obtain a HELOC. Some non-depository mortgage lenders offer them as well.
Quick facts about a home equity line of credit (HELOC)
Here are some quick facts about a HELOC.
- Lines are generally based on a 30-year repayment term.
- The interest rate is based on a margin and prime rate (which is set by the Fed).
- Interest rates are usually adjustable, and some HELOCs offer a temporary fixed rate period.
- As you pay down your principal, you can borrow additional credit.
- HELOCs can have a pre-payment penalty.
- During the drawdown period, your minimum monthly payment is generally just interest. You’ll have to make additional payments if you want to pay down your principal.
- There can be closing costs associated with obtaining a HELOC.
- Your payment can adjust as interest rates adjust and as the balance changes.
Think of a HELOC as if it were a credit card; both debt obligations are fluid and subject to change over time.
How to make a decision on a home equity loan vs. a home equity line of credit.
Using math to compare the long-term cost between a HEL and HELOC is challenging to calculate because the purpose and use of each debt obligation are different.
For example, comparing a lump sum HEL debt obligation of $100,000 to a $100,000 HELOC that has a zero balance but will be used over time depends on what interest rate the HELOC will have when the homeowner accesses the line of credit along with what payments have been previously made.
A better way to compare the two is to look at four important considerations before deciding which is better, a HEL or a HELOC, which I will do below, and then follow up with a calculation you can do to compare the two (with all things being equal in terms of starting balances and interest rates).
The purpose of obtaining additional debt
The purpose of obtaining additional debt is the most important component in deciding whether to go with a Home Equity Loan or a Home Equity Line of Credit. Generally speaking, and all things being equal, if you need a lump sum immediately and want to start paying the principal back each month, then a HEL might be the best option for your financial goals.
If you don’t need a lump sum right now and will only need the funds over time, a HELOC might better fit your financial goals.
Clearly defining the purpose of obtaining additional debt has to be your first step in making a decision on whether a Home Equity Loan or a Home Equity Line of Credit is better for your financial goals.
Find the best way to unlock home equity
Are you a risk taker or risk-averse?
Home Equity Loans are less risky than Home Equity Lines of Credit (even with a temporary fixed rate option).
Knowing your rate and payment for the entire life of the HEL provides a certain level of security that a HELOC can’t offer. If you dislike or if you welcome risk, you should factor that into your decision-making.
Home Equity Line of Credit, The Risk Factor You Need To Know
Home Equity Lines of Credit have a floor rate and a ceiling rate. And depending on what the Fed does, your interest rate might move higher than anticipated.
The Home Equity Line of Credit risk factor you need to know is the ceiling rate associated with the HELOC you are considering. Most HELOC ceiling rates are significantly higher than the start rate (which is sometimes lower than your actual rate when the starter period is over) and current prevailing HELOC rates.
It’s not uncommon to see HELOC ceiling rates in the high teens and into the twenty percent range.
Before you decide, consider the fees
Yes, there are fees associated with a Home Equity Loan and a Home Equity Line of Credit. The fees you pay to obtain a HEL or a HELOC will factor into your decision-making, and there is no rule of thumb that one option is more expensive than the other. Home Equity Loans and HELOCs both have closing costs. They include:
- Underwriting
- 3rd party fees (appraisal, closing agent, etc.)
- Recording fees
Some lenders will offer a “lender credit” to help cover the costs associated with a HEL or a HELOC. Just know that a higher rate offsets the lender credit. Remember the following rule of thumb when making financial decisions: nothing is for free.
A pre-payment penalty might change your mind
If you have to pay a pre-payment penalty, that could be costly, so let’s cover your potential risks if the HEL or HELOC you’re considering has one.
Pre-payment penalties are fees you will owe if you pay off the HEL too early or, concerning the HELOC, close the line of credit too soon. Regarding a HEL, the amount can usually be 1.00% to 3.00% of the amount borrowed.
If your HEL amount is $100,000 and your pre-payment penalty is 3.00%, then your early payoff fee is $3,000.00. If the HEL has a pre-payment penalty, it most likely will be in place for two to five years.
When it comes to fees and Home Equity Lines of Credit, it’s usually the cost the lender incurred to underwrite the HELOC plus additional fees. Always ask your loan officer if their offer option includes a pre-payment penalty. You’ll want to add that potential amount to your decision-making if it does.
Using math to compare a HEL vs a HELOC
To compare a HEL and a HELOC, two things must be assumed when it comes to a HELOC. The homeowner will access the credit line at the beginning of the term, at the same balance as the HEL and the prevailing HELOC interest rate at the time it needs to be used.
Here is the information you’ll want to find out to compare a HEL to a HELOC.
Home Equity Loan
- Fees to obtain the HEL
- Interest rate
- Re-payment terms
- Monthly payment
- Total interest paid
Home Equity Line of Credit
- Fees to obtain the HELOC
- Interest rate
- Re-payment terms
- Monthly payment
- Total interest paid
Once you have the above information, it’s just a matter of doing a little addition to find your total cost.
Fees + total interest paid = Total cost
This can get tricky because all Home Equity Loans have a monthly payment based on principal and interest. In contrast, a Home Equity Line Credit has an interest-only payment during the initial draw period (which can be up to ten years).
When comparing the two, compare the total interest paid and not just monthly payments.
Mortgage pro tip for home equity lines of credit
If you want a HELOC, consider getting a total line for more than you need. Previously, I mentioned that you could think of a HELOC like a credit card. What happens to your credit score when you max out your credit card? It goes down—and not just a little bit.
The same thing will happen with a HELOC if you max out the total approved credit line.
If you expect to need $50,000 from your HELOC, try to get a HELOC with a total line of $100,000. Ideally, you’ll want the line to be $143,000 or more since $50,000 is less than 35% of the total line. There will be no negative impact on your credit score at this level.
Should you go with a HEL or a HELOC?
If you have done the work, you can make this decision with little input from others. Empowering yourself with information is a key to long-term wealth.
When you start the process of deciding which is better for you, I suggest you follow the order of decision-making as I have listed above: the purpose of obtaining additional debt, determine if you don’t mind risk or if you are risk-averse, consider the home loan fees you are paying, and if there is a pre-payment involved.
Once you have that information, it will be much more apparent if a Home Equity Loan or a Home Equity Line of Credit is the better tool for you to meet your long-term financial goals.
