When you find yourself in need of a large sum of money—whether for an emergency medical expense, a home improvement project, or any other big life expense—you probably start researching the best loan option for your unique situation. In particular, if you’re a homeowner, you might consider tapping into your home equity with either a home equity loan or a home equity line of credit (HELOC). But which is the better choice?
Borrowing against your home equity can be a cost-effective way to get the funds you need, with the potential for favorable interest rates and flexible repayment terms. It can also come with a serious risk, as you’re putting your house up as collateral, meaning you could lose it if you default on repayment.
We’ll walk you through these two ways of tapping your equity, with one being a form of installment credit and the other being a revolving line of credit somewhat similar to a credit card.
What is a home equity loan?
Think of a home equity loan as something like a secured personal loan. It’s a way to borrow from the value you’ve built in your home as you pay down your mortgage. The money you receive from a home equity loan is backed by your property—so if you don’t pay off your loan, the lender may sell your house to recoup the balance you owe.
When you take out a home equity loan, you’ll receive a lump sum deposited into your bank account. You can use it for nearly anything, similar to a personal loan. You’ll be set up on a payment plan of equal monthly installments until your loan (plus interest) is repaid. You may get up to 30 years to repay your loan.
There are key differences between a differences between a personal loan and a home equity loan, however. Home equity loans allow you to borrow potentially more than a typical personal loan, which is often capped at $100,000. Depending on the amount of equity you’ve built, a home equity loan might offer hundreds of thousands of dollars in borrowing power. The interest rate can often be lower than many other types of loans, too.
That said, a home equity loan can be costly to open. Some lenders charge for things like origination fees, credit report fees, title search fees, and more.
Pros and cons of a home equity loan
Pros
- APR is fixed for the duration of your loan
- Predictable monthly payments
- Typically slightly lower APR than a HELOC
Cons
- You’ll pay interest on the full borrowed amount (whether you use it immediately or not)
- You may lose your home if you fail to pay off your loan
- Lowers your home equity until repaid
What is a HELOC?
A home equity line of credit is similar to a traditional home equity loan in that you’re borrowing from your property’s equity. You can likely enjoy competitive APR and a potentially higher borrowing amount when compared to a standard personal loan—but default on your loan, and you could lose your home.
The big difference between a home equity loan and a HELOC is the way you can spend your money. Instead of an upfront lump sum deposited into your account, your funds are delivered in the form of a revolving credit line (similar to a credit card, in that you borrow as needed rather than all at once). You’ll only be charged interest on the portion of your credit line that you actually use.
A HELOC is comprised of a “draw” period and a “repayment” period. The draw period begins when you take out your loan and can last up to 10 years. During this time, you can borrow and repay essentially as you please. When this period closes, the repayment period begins. You can no longer use your credit line, and you’re required to repay it back—either all at once or through a monthly installment plan. Similar to a home equity loan, the repayment period can last decades.
It’s also worth noting that you may be able to refinance your HELOC to regain access to your line of credit.
Expect similar closing costs whether opening a HELOC or a home equity loan, from appraisal fees to origination fees.
Pros and cons of a HELOC
Pros
- Revolving credit structure lets you reuse this financing method multiple times
- You’ll only pay interest on the funds you use
- Initial interest-only payments keep upfront costs low
Cons
- You may lose your home if you fail to pay off your loan
- Interest rates are typically variable
- Lowers your home equity until repaid
Requirements to borrow from your home equity
To qualify for either a home equity loan or a HELOC, you’ll have to:
- Be a homeowner
- Have considerable equity your home
Equity is the value of your property minus the amount you owe on your mortgage. Lenders commonly require you to keep between 15% and 20% equity in your home. In other words, you can generally borrow anything above that number.
For example, if your home is worth $350,000 and you owe $200,000 on your mortgage, you’ve got $150,000 in equity—or 43% ($150,000 in equity / $350,0000 total value). If you’re required to keep 20% equity in your home, you could borrow up to 23% of your equity.
Beyond this stipulation, lenders also look for a good credit profile, proof of income and employment, and reasonable debt-to-income ratio, preferably below 40%.
How to decide between a home equity loan and a HELOC
So, you’ve decided that borrowing from your home equity is the best strategy to fund your large upcoming purchases. If you’re still unsure which is best, ask yourself the following questions.
What do you need the money for?
If you need money for a single large purchase, a home equity loan may be the way to go. Its repayment terms are straightforward and its APR is predictable. A HELOC may be better if you don’t need all the money immediately but you plan to use it incrementally, as you’ll only be charged interest for the money you’re currently using (instead of the entire loan amount).
Will you use the funds for ongoing spending?
If you plan to access your equity multiple times, a HELOC is the clear winner. Again, you can use it similar to a credit card—but without the eye-watering APR. It’s also handy to keep simply as an emergency fund.
Do you want a fixed APR?
While it’s possible to receive fixed interest rates for a portion of your HELOC, this loan type is typically subject to variable APR. Depending on market conditions and Fed decisions, that can be a good thing or a bad thing.
Either way, your interest with a HELOC is generally less predictable than with a home equity loan with interest rates that are locked in upon account opening.
How much equity do you have?
If you don’t have much equity, a home equity loan may not be the optimal choice. A more strategic option may be opening a HELOC, as it allows you to borrow from the same credit line as often as you pay it back. This allows you to effectively borrow more than your equity—just not all at once.
For example, you may want to finance your $50,000 home renovation with equity. If you’ve only got $10,000 in equity, a home equity loan won’t cover your needs. But with a HELOC, you can buy your materials and/or pay for labor $10,000 at a time. When you pay down your balance, you’ll be able to borrow from your equity again.
Other ways to finance a purchase
A home equity loan and a HELOC are just two options to finance your large purchases. Other popular choices include:
- Buy Now Pay Later (BNPL) services. Some purchases qualify for BNPL options which split an expense into multiple interest-free transactions.
- Credit cards. These are ideal for everyday purchases you can pay off in full promptly but generally a bad option for funding large expenses that will take months to pay off. The APR is often high—though some credit cards come with an initial interest-free window which can give you a year or even nearly two to pay off your balance without paying interest.
- Borrow money from friends or family. If you’ve got the implicit trust of those close to you, borrowing money can be the easiest and cheapest way to fund a large purchase. But, make sure to outline clear terms for the repayment and stick to the agreement, otherwise you risk damaging these relationships.
The takeaway
A home equity loan and a home equity line of credit are similar in many ways, from associated costs to borrowing amounts to repercussions of failing to pay back your loan. The key difference is in how you access the funds.
A home equity loan deposits a large sum into your bank account and enrolls you in equal monthly installments until your loan is repaid. A HELOC gives you a revolving credit line from which you can borrow and repay over and over again.
Frequently asked questions
Is a home equity loan a second mortgage?
Yes, a home equity loan is a second mortgage. Taking out a home equity loan means you’ll now have a monthly mortgage payment and a monthly loan payment.
Which is better for a large one-time expense: HELOC or home equity loan?
A home equity loan is generally better for a large one-time expense, as its interest rates are fixed and its repayment terms are predictable.
Can my monthly payment change with a home equity loan?
Your monthly payment cannot change a home equity loan. When you open your account, you’ll be enrolled in fixed equal monthly installments until your loan is paid off.
How much equity do I need to qualify for a HELOC?
To qualify for a HELOC or home equity loan, you typically need more than 15% to 20% equity in your home. This is because most lenders require that you keep at least that much equity in your property at all times.
Do I need an appraisal for a home equity loan or HELOC?
Yes, you generally need an appraisal for a home equity loan or HELOC so the lender knows how much money to extend to you.