As housing prices rise across the country many people are looking into how they can use their home equity to receive low-interest financing¹. If you’re exploring lending options you may wonder what the difference is between a home equity loan and a home equity line of credit. First let’s define both types of financing and then outline the major differences.
What is a home equity loan (HEL)?
A home equity loan lets you borrow a fixed amount, secured by the equity in your home, and receive your money in one lump sum. The amount you can qualify for is based on your home’s Loan to Value ratio, payment term, verifiable income and credit history. Typically, home equity loans have a fixed interest rate, fixed term and fixed monthly payment. Interest paid on a home equity loan may be 100% tax deductible (consult your tax advisor to see if you qualify).
What is a home equity line of credit (HELOC)?
A home equity line of credit is a kind of revolving credit that allows you to borrow money as you need it with your home as collateral². Lenders approve applicants for a specific amount of credit based on taking a percentage of their home’s appraised value and subtracting the balance owed on the existing mortgage. They may also consider your income, other debts and credit history.
If you’re approved for a HELOC you can usually spend the funds however you want (up to the credit limit) using special checks or a credit card. However, some plans have restrictions or guidelines that require you to borrow a minimum amount each time, keep a minimum amount outstanding or withdraw an initial advance when the line of credit is established.
Most HELOC plans allow you to draw funds over a set amount of time known as the “draw period”. At the end of this period you may be able to renew the credit line and keep withdrawing money, but not all lenders allow renewals. Some lenders require borrowers to pay back the entire amount at the end of the draw period and others may allow you to make payments over another time period known as the “repayment period”.
How is a home equity loan different from a home equity line of credit?
The two major differences between a HEL and a HELOC are the interest rates and repayment policies.
A home equity loan typically has a fixed interest rate while a home equity line of credit typically has a variable rate. A fixed interest rate means the borrower can be sure the amount they pay on the loan will be the same each month. A variable interest rate means the amount of money you’re spending for the privilege of financing can go up or down. This variable is based on a publically available index (like the prime rate or U.S. Treasury bill rate) and will fluctuate with this index. Lenders also usually add a “margin” of a few percentage points. When looking into HELOCs it’s important to understand the following from the lender:
- Which index is used and what is the current variable?
- What amount of margin do you charge?
- What is the frequency rate of adjustment?
- What is the interest rate cap and floor?
The other significant difference is the method of repayment for the loan. Home equity loans are paid back with the same fixed amount monthly, made up of both principal and interest payments. Some loans allow borrowers to pay back larger sums if they choose (say if you receive a work bonus and want to put it toward the debt) but others charge a penalty for early payments. Typically at the end of the loan term the amount is paid in full³.
Repayment of some HELOCs works the same way, except the monthly interest payment may shift with the index. But many HELOCs only require borrows to pay the monthly interest. This means if you borrow $10,000 you may only pay interest (and no principal) over the course of the draw period, but at the end of the draw period the entire $10,000 is due back to the lender. This is known as a balloon payment. If you are unable to make this payment you will have to refinance the amount with another lender, potentially at unfavorable interest rate.
Carefully weigh the pros and cons of each of these types of loans before tapping into your home equity. Shop around for the best rate available and the terms that best meet your financial goals. The good news is both of these secured loans usually have lower interest rates than unsecured loans.
Legal Disclaimer: The articles and information provided herein are for informational purposes only and are not intended as a substitute for professional advice.