Recently, homeowners have turned to their equity to meet their cash needs.
After all, most of them already have a very low fixed interest rate on their mortgage and do not want to bother with it in any way.
If they were to go the cash-out refinancing route, they would lose the old low interest rate and end up with a much higher rate.
To avoid this, they can take out a second mortgage instead and keep the existing first mortgage as is.
The question is: Do you choose a HELOC or a home equity loan?
How are HELOCs and home equity loans similar?
If you’re like many people trying to understand the difference between a home equity line of credit (HELOC) and a home equity loan, allow me to help.
There are three main differences between the two, although both options share many of the same qualities. Let’s discuss those first before we get into their differences.
First, they both often act as a second mortgage. Both allow you to leverage your home equity.
You can get cash from either and you can do so without compromising your first mortgage.
Nothing changes with your first mortgage when you get a second mortgage like a HELOC or home equity loan.
That’s a good thing if you’ve got one of the 3%, 30-year fixed mortgage rates that have been available for most of the past decade.
So whichever option you choose will allow you to continue enjoying this low rate, unlike a cash-out refinance, which would pay off your old loan and create a new one.
If that makes sense, let’s move on to the three main reasons why they’re different.
HELOCs are open lines of credit, and home equity loans are lump sum payments
Now for those key differences. One of the biggest differences is that a HELOC is an open-end line of credit, while a home equity loan is a closed-end, lump-sum loan.
Let’s discuss the home equity loan first because it’s easier to understand. You apply for X amount of dollars and receive that amount at closing.
For example, if you apply for a $50,000 home loan, you will get $50,000 at closing and pay it back monthly.
It’s a one-time deal that allows you to borrow a set amount, just like a home loan.
Except that they are taken out by existing homeowners who leverage their equity and then use the proceeds for anything they want, such as another investment, college tuition, other high-cost debt, etc.
On the contrary, A HELOC works more like a credit card Where you apply for a line of credit and then borrow from it as much or as little as you want.
Using the same $50,000 example, you would get a line of credit of $50,000 using your home equity as collateral.
You can then borrow from it as you wish, or perhaps keep it open as an emergency line if cash needs arise in the future.
You can also borrow from it multiple times during the draw period, which is often up to 10 years.
So you could borrow the entire line ($50,000), pay off part of it, and then borrow again during that window.
With a home equity loan, You can only borrow once. Simply put, a HELOC provides more flexibility, similar to a credit card. Whereas a home equity loan works like a standard loan.
advice: Pay attention to the loan origination fee (if applicable), which may apply to the initial draw or the full loan/line amount when comparing options.
HELOCs are variable rate, and home equity loans are fixed rate
The next big difference is that HELOCs are variable interest rate loans, while home equity loans are fixed rate loans.
A home equity loan might have a fixed rate of 9% or 10%, for example, and it will remain there for the entire term of the loan.
There will be no price adjustments, so you’ll enjoy guaranteed payment every month.
Plus, since a home equity loan is a lump sum loan, you’ll know exactly how much your payment will be each month. It won’t change.
Meanwhile, the HELOC is tied to the base rate, which is driven by the Federal Reserve. Whenever the Fed lowers or raises interest rates, the key interest rate will move by the same amount.
For example, the Federal Reserve recently cut interest rates by half a point and then another quarter point.
This brought the interest rate down by 0.75%, so those who already had HELOCs saw their interest rate drop by that amount.
In other words, a HELOC holder with an 8% rate now has a rate of 7.25%. A nice feature if prices drop. But they can also go up.
Due to this uncertainty, HELOC interest rates are generally lower than home equity loan rates.
advice: The Federal Reserve is expected to continue lowering interest rates through 2025, so HELOC interest rates will likely fall even further.
HELOCs come with an interest-only period
The final difference between these two loan products is that HELOCs offer an interest-only period.
During the draw period of a HELOC (when you are able to withdraw funds from the line of credit), the minimum payment required is usually interest only.
So you don’t need to pay back the principal (the amount you borrowed). You only need to pay the interest portion. Often, this is an option for up to 10 years.
as a result of, You can enjoy a lower monthly payment during the withdrawal periodlikely less than a comparable home equity loan, which requires full repayment from the beginning.
The upside is that you have smaller monthly payments. The downside is that you may pay more interest if you don’t repay the loan until later.
Once the draw period on your HELOC expires, your payments will jump as the loan amortizes over the remaining term, perhaps 20 years or less.
This means that the choice between the two may depend on cash flow, as a HELOC offers greater payment flexibility. And borrowing options initially.
A home equity loan provides peace of mind with a fixed rate, but it also requires you to borrow the full amount at closing, which you may not actually need. You cannot rely on it again in the future.
To summarize, HELOCs are open-ended, variable-rate lines of credit with multiple payment options.
While home equity loans are closed-end loans, they are lump-sum loans that require fully amortizing payments including principal and interest.
Take the time to compare the two to make sure you get the right product for your unique situation.
One final wrinkle is that some lenders now offer fixed-rate HELOCs, such as a home equity line, so comparing products may be more difficult.
Read on: Cash Out vs. HELOC vs. Home Equity Loan: Which Is the Better Option Now and Why?
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