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Home Equity Line of Credit vs. Home Equity Loan: What are the Differences?

May 28, 2021 by Daniel Azzoli

white house during the fall

One of the main benefits of owning a home is that the further down the road you get with your mortgage payments, the more equity you build up in it. Investing in this type of asset can be a big boost to your financial portfolio in the long run, but there are some other potential benefits to building up equity in your home.

One of them is that once you get to the point where the amount of equity you have in your home is higher than the remaining balance on your mortgage, you might be able to use this equity to secure a loan that comes with relatively low rates. This loan can come in the form of either a home equity loan or a home equity line of credit (HELOC).

In both cases, these loans can give you access to funds for things like home improvement projects, educational expenses, or more. But while they both allow you to borrow money against the equity you have in your home, there are some important details that make each distinct from the other. Today, we’re going to define both terms, look at some of their important details, and compare and contrast their potential benefits.

What is a Home Equity Loan?

A home equity loan is a secured loan that you can only qualify for by providing equity in your home as collateral (amongst other things). They’re essentially a type of installment loan where you’ll apply for a specific amount, and if you’re approved, you’ll receive your funds in a lump sum. You’ll then pay off your loan over the course of several scheduled and equal payments that come with a fixed rate.

Small modern home with wet driveway

How Long is a Home Equity Loan and How Much Money Can I Get?

Not only will you need to provide the equity you have in your home as collateral, you’ll also need to have a certain amount of equity in order to qualify. More specifically, the amount of equity you have has to exceed the remaining balance on your mortgage[1].

The amount that you qualify for is going to vary based on several factors. First off, the combined loan-to-value (CLTV) ratio is going to play a big part. This number compares the total amount of secured loans on a property with the total value of the property itself[2]. Generally, the size of the loan can be up to ninety percent of the value of the property.

The loan issuer will also look at other factors to determine whether or not to approve you for the loan you’re applying for. This will likely include your credit score, which is a three-digit number that’s meant to summarize the type of borrower you are. It takes things like your previous ability to meet your payment due dates, how much debt you have, and other factors into account to determine your credit score.

What Will the Payments and Interest Rate be on my Home Equity Loan?

Like we mentioned earlier, home equity loans typically come with a fixed interest rate, which means that the rate will stay the same for the duration of your repayment schedule. Your payments will also typically all be the same amount. Part of every payment will go towards paying off your interest, while another part will contribute to paying off your principal balance.

Generally, the length of a home equity loan can vary from anywhere between five and thirty years, based on the lender and certain other factors. Regardless of how long you’ll be paying off your loan, your repayment schedule should be fairly stable and consistent.

What is a Home Equity Line of Credit?

While there’s definitely some overlap between a home equity line of credit vs. home equity loan, there are also some important differences. One of the main ones is that a home equity line of credit is a type of revolving credit. This means that if approved, you’ll be given a credit limit which you can borrow money from, repay, and borrow again.

Person signing a contract for a home equity loan

This borrowing system is significantly different from a home equity loan, where you’ll receive all your funds upfront. With a HELOC, you can borrow money when you need it, and it stays available to you until the term of the loan is up. Because there can be some variance in the amount of money you’re borrowing each time you tap into your HELOC, the size of your payments can also change depending on how you use your line of credit.

What are the Interest Rates of a HELOC?

Just like a home equity loan, a HELOC is a secured form of credit that requires you to put your equity in your home up as collateral. While a HELOC may have a lot in common with other types of lines of credit and credit cards, an important distinction is the secured nature of a HELOC. If you end up defaulting on this type of loan, there’s a chance that you could end up losing your house.

Generally, the interest rate of a HELOC will be variable. This means that over the term of your loan, the rates can go up and down. The amount required to meet your minimum payment – the minimum amount you need to keep your account in good standing – can also change as rates fluctuate. Having said that, there are certain lenders who provide fixed interest rates on HELOCs. These rates will be determined by similar factors to home equity loans, like your credit score.

Draw and Repayment Phases of a HELOC

HELOCs are unique from a lot of other types of lines of credit in that they are split into two phases. The first phase is called the draw period, and the second is the repayment period. Like it says in the name, the draw period is the portion of the term where you can draw funds from your HELOC. Once this portion comes to a close, you won’t be able to draw money from your line of credit anymore.

One important thing to note here is that even though it’s called the draw period, you still need to be making payments during this time. Generally, these payments will just go towards paying off the interest of the loan, making them relatively small. Once you transition into the repayment period, you’ll start making contributions towards your principal balance. Keep in mind that the transition from only paying off the interest to then paying off interest and your principal is a significant jump up. Make sure you’re prepared for this switch and that you budget accordingly.

Important Differences Between a Home Equity Loan and Line of Credit

If you’re trying to decide whether to apply for a HELOC vs home equity loan, a lot of what this decision is going to come down to is what you need the loan for. If you’re about to undertake some big home renovations and you don’t know what the final cost is going to be, the flexibility of a HELOC may be what you’re looking for. If you run into some extra costs, you won’t need to apply for another loan – you can simply draw more funds from your line of credit, pay them off, and draw funds again as needed (as long as you’re still in the draw period).

Person wearing one orange and one blue shoe.

Having said that, there’s no guarantee that your HELOC won’t be revoked if certain things take a turn for the worse. If something goes wrong with your financial situation or the housing market takes a dip (along with the value of your home), a lender could lower your credit limit, or potentially close your account. So, while a HELOC is meant to provide you with the flexibility you need to access money when you need it, there’s a chance that this ability gets revoked.

On the other hand, if you need to borrow a large amount of money and know exactly how much you’ll need, a home equity loan may be a good choice. If you get approved, you’ll be given all your money right away which can be useful for things like paying for your child’s college, and more. The scheduled nature of the repayment phase can also be beneficial, as it may make it easier for you to plan out your budget in advance.

Only Borrow Money When You Need it

It can be useful to potentially have access to a big loan with relatively low rates through the equity you have in your home, but that doesn’t necessarily mean that it’s a good idea to take advantage of it. Whenever you’re thinking of applying for a loan, you’ll need to ask yourself some important questions. What do you need the money for? How will this affect you in the long and short term? Will you be able to afford to repay what you’ve borrowed? The answer to these types of questions will help to inform what type of loan you should apply for, and if you should apply for one at all.

So before you submit any applications, look at your budget, do some research on what type of financial products are out there, and try to find a solution that’s best suited to your situation!

 


 

[1] https://www.investopedia.com/mortgage/heloc/home-equity-vs-heloc/

[2] https://www.investopedia.com/terms/c/combinedloantovalue.asp


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