Know the differences between a home equity loan and a home equity line of credit
For homeowners, using your home’s equity to secure a loan or a line of credit is an attractive, low-interest way to raise money. While there are slight differences between a home equity loan and a home equity line of credit (also known as a HELOC), they both offer higher borrowing limits than unsecured personal loans. When deciding between home equity loan vs. home equity line of credit, you’ll want to know the basic distinctions between these personal financing options to find the one that matches your needs.
What is a home equity loan (HEL)?
The money you have invested towards owning your home (your home’s equity) can be used as security for home equity loans:
- After you loan closes, the entire amount of your loan will be deposited in the account(s) you select.
- Most lenders will consider lending home equity loan amounts that are equal to 85% of the borrower’s home equity, though Discover Home Loans lends less than 90% in certain circumstances.
- The interest rate for a home equity loan is typically a fixed rate which gives borrowers the assurance of fixed monthly payment.
- A home equity loan repayment period will typically last 10-30 years at a low interest rate with consistent monthly payments.
- Many home equity loans will also include closing costs, however, when you take out a home equity loan with Discover, borrowers pay no origination fees and no cash due at closing.
- Interest payments on home equity loans may be tax deductible under certain conditions when the loan goes towards home renovation expenses although you need to check with your tax advisor.
What is a home equity line of credit (HELOC)?
Your home’s equity can be used as security for home equity lines of credit, a type of revolving credit:
- On the first day of a home equity line of credit, you are given access to an account with the agreed credit limit. You are charged interest only on any withdrawals from the account, which can make the repayment amounts of home equity lines of credit less consistent from month-to-month.
- Most lenders will consider home equity line of credit limits that are equal to 85% of the borrower’s home equity.
- With a variable interest rate, home equity lines of credit may offer a lower starting interest rate than home equity loans, but the interest rate can change based on U.S. economic trends.
- Some HELOCs allow monthly payments towards the principal of the loan to be delayed until the final day of the loan. While this can lower your monthly payments, it can also create a balloon payment when the loan ends. Borrowers should check when applying for HELOCs to understand the full repayment schedule for the line of credit.
- A HELOC repayment period will typically last 5-30 years at a low interest rate with monthly payments and interest that depend on how much is withdrawn and the according interest rate at the time of withdrawal.
- A home equity line of credit will define a withdrawal period, which is the time period when you can withdraw funds from the line of credit. When the withdrawal period expires, you may apply for renewal of the line of credit, but approval of that renewal will be at the discretion of the lender.
- Aside from closing costs, HELOCs may charge fees for each withdrawal from the line of credit as well as annual fees for service during a withdrawal period.
- Like a home equity loan, interest payments on home equity lines of credit may be tax deductible when the expenses are for home renovation although you need to check with your tax advisor.
Differences between a home equity loan and a home equity line of credit
As you weigh the differences between a fixed loan vs. a line of credit, you will find some minor differences between the two products:
Fixed Interest Rates vs. Variable Interest Rates
A home equity loan charges interest at a fixed rate, while most home equity lines of credit charge interest at a variable rate.
Fixed interest rates provide you with predictable repayments, allowing your home equity loan lender to provide you with a schedule for stable repayment amounts over the life of the loan.
Variable interest rates are based on the interest rate on a standard index (such as the bank’s prime rate or U.S. Treasury bill rate) and will therefore fluctuate, based on factors of the U.S. economy. Interest rates for HELOCs will likewise change as your line of credit matures.
As you compare the variable interest rates for HELOCs, you will want to know:
- Which index is used and what is the current variable?
- What amount of margin does the lender charge?
- What is the frequency rate of interest rate adjustment?
- What is the interest rate cap and floor?
Lump Sum Disbursement vs. Withdrawals as Needed
Another difference between a HELOC and a home equity loan is how you receive the money.
A home equity loan is dispersed as a lump sum: the entire loan amount will be deposited into your preferred account(s).
A home equity line of credit is typically set up as a separate account from which you can withdraw the funds only as you need them.
Additionally, a home equity line of credit will assign a withdrawal window: you will only be able to withdraw funds during that time period. When that window expires, you can apply for an extension to the line of credit, but your request may not always be granted.
When you take out a home equity loan with Discover, we pay for any closing costs up front: allowing you to save some money to start.
Fees and Penalties
Both home equity loans and home equity lines of credit will assess a variety of closing costs and can include prepayment penalties if you pay back the loan before the scheduled term. Your lender should provide you these fees and penalties up front so you can evaluate which lender provides the most attractive terms.