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HELOC vs Home Equity Loan: similarities, differences, and how to choose
By Jane Meggitt
Published on February 28, 2023
Read time: 6
Both HELOCs and home equity loans allow you to borrow against your home’s equity to pay for large expenses like home renovations or refinancing your credit card debt.
A HELOC works like a credit card during the first few years, and then like a mortgage.
A home equity loan works like (and is) a mortgage
You’ve got goals. Knocking down costly debt. Knocking down a wall to create an open floor plan. Whatever it is, you need money to make it happen.
Tapping into your home equity can provide you with the funds you need for debt consolidation, home improvement, college tuition, or other large expenses. You can borrow against your equity with either a home equity line of credit (HELOC) or a home equity loan.
We’ll explain how each option works and how to choose the best one for your needs.
HELOC and home equity loan similarities
HELOCs and home equity loans are similar in many ways:
The loan is tied to your home equity
How much you can borrow with either a HELOC or home equity loan depends on the amount of equity you have in your property. Equity is your home’s value minus what you still owe on the mortgage. For instance, if your house has a current market value of $300,000 and you owe $100,000, your equity is $200,000 or 67%.
The loan amount is limited by your loan-to-value ratio
All lenders limit the amount that you can borrow against your home. That limit is expressed as loan-to-value or LTV.
LTV is the opposite of equity. If your equity is 67%, the LTV is 33%. Generally, to qualify for a home equity loan or HELOC, your combined LTV (your primary mortgage plus the new loan that you want) can’t exceed about 80% of your home’s market value (some lenders may allow you to borrow more).
Let’s go through an easy example to help you make the calculations.
Your home is worth $300,000
Your current mortgage balance is $100,000
The lender’s maximum allowable debt on the home is 80% or $240,000
You could borrow an additional $140,000
The lender will ask why you want the funds
You can use HELOCs and home equity loans for almost—but not quite—anything. Some uses include:
Credit card refinance
Medical and dental expenses
Appliances and electronics
Restrictions on how you can use your loan depend on the lender. For instance, some lenders won’t approve a home equity loan for starting a business. Let your lender know what your financial goals are to make sure you’re applying for a loan that'll meet your needs.
The differences between a HELOC and home equity loan
Lump sum vs. a line of credit
With a traditional home equity loan, you receive all the money at once, even if you don’t need it all right away. You’ll pay interest on the entire amount that you owe from the day you get your loan, even if you haven’t spent it yet. This could be a good way to borrow if you have a large expense to cover immediately.
A HELOC is a line of credit—that’s why it’s called a “home equity line of credit.” During your draw period (a few years or longer), you can withdraw money as you need it. It’s sort of like a credit card in that you can borrow, repay, and borrow more as often as you like, up to your credit limit. A HELOC could be a big advantage if, say, you’re fixing up your home yourself, and you don’t plan to spend all of the money immediately or don’t know how much you’ll need overall.
Your monthly payment
With a traditional home equity loan, as soon as you get your loan, you’ll start making a monthly payment that won’t change until your loan is paid off.
With a traditional HELOC, you might only have to make interest-only payments during the draw period. Then, when the draw period ends, your payment would spike sharply to a much higher amount.
With a fixed-rate HELOC, you’ll make a principal-plus-interest payment based on your loan balance, even during the draw period. This can help prevent the payment shock associated with traditional HELOCs.
Different types of interest
Home equity loans and HELOCs almost always have interest rates lower than credit cards or personal loans. Even so, you’ll want to look carefully at what kind of interest the loan comes with:
Traditional home equity loans usually have a fixed interest rate. A fixed rate protects you against economic fluctuations that could make your loan more expensive.
Traditional HELOCs have a variable interest rate during the draw period, similar to credit cards. Many traditional HELOCs convert to a fixed rate when it’s time to stop borrowing and start repaying your loan.
A hybrid HELOC, sometimes called a convertible HELOC, can be confusing. Some versions allow you to lock an interest rate on portions of your balance a few times (usually two to five) during your draw period, and you may have to withdraw money before you can lock a rate. Other versions can switch from a variable rate to a fixed rate and back to a variable rate.
A fixed-rate HELOC gives you a fixed interest rate on the day your loan is approved. Throughout the draw period and repayment period, the rate remains the same.
Fees and closing costs
Fees and closing costs for HELOCs and home equity loans are similar to those for mortgages. Fees vary and can include:
Application fee - for applying
Origination fee - the lender’s fee for processing your loan
Appraisal fee - paid to a professional appraiser for estimating the home’s value
Underwriting fee - paid to the person who handles your loan documents
Credit report fee - for requesting a copy of your credit report
Title search fee - for proving that you legally own your home
You should expect the grand total to range from 1% to 5% of your loan amount, depending on the state where you live and how much you borrow.
Some traditional HELOCs charge additional maintenance fees for keeping the account open, an inactivity fee if you don’t keep withdrawing funds, or transaction fees for withdrawals. Hybrid HELOCs may charge a fee every time you lock a rate. A better HELOC lender won’t charge these fees.
How to choose between a HELOC and a home equity loan
HELOCs and home equity loans can be the right solution in different situations.
When is a home equity loan a good choice?
Consider a home equity loan when you have a large, predictable expense that you plan to spend the money on right away. Most home equity loans have a fixed interest rate, so your payments will be steady for the entire loan term.
When is a HELOC a good choice?
If you don’t need the full amount of your loan upfront or you aren’t sure how much you’ll need, a HELOC might be a better choice. You’ll be able to access funds as needed over several years. You’ll only pay interest on the amount you borrow, not on the full credit limit.
Even if you borrow the full amount when your HELOC is finalized, you could borrow more, up to your credit limit, later in your draw period after you have paid down some of your balance.
A third choice: fixed-rate HELOC
If a line of credit is right for your situation, a fixed-rate HELOC is usually the best option. Traditional HELOCs have unpredictable payments due to their variable interest rates. On a fixed-rate HELOC, your rate is locked when you get the loan. No uncertainty about future costs.
Frequently asked questions - HELOC vs home equity loan
What is a HELOC and how does it work?
A home equity line of credit (HELOC) is a way to borrow against your home. You can borrow, repay, and borrow more, over a set period of time called a draw period. You pay interest only on what you borrow, not the entire line of credit. Once the draw period ends, you may not borrow anymore.
Traditional HELOCs have a variable interest rate during the draw period and convert to a fixed-rate loan when the draw period ends. With a fixed-rate HELOC, you lock in your rate when you get your loan.
Traditional HELOCs require interest-only payments during the draw period. On a fixed-rate HELOC, you’ll make a principal plus interest payment based on your current loan balance.
This is a loan against your home, just like a mortgage. If you fail to repay it, the lender can take steps to sell your home and recover their losses.
What is a home equity loan and how does it work?
A home equity loan is a way to borrow against your home. A home equity loan works the same way as a mortgage. Once your loan is approved, you'll receive the entire amount. Your required monthly payment will be the same for the life of the loan.
Is getting a home equity loan complicated?
Getting a home equity loan or HELOC is similar to getting a mortgage. Lenders use the same criteria as with any mortgage application. They will hire a professional appraiser to find out your home’s value. They will check your credit, income, and debt. You’ll need to supply documentation such as recent pay stubs and income tax forms so that the lender can determine how much of a payment you can afford. Most home equity loans require good credit scores, but some lenders have more flexible requirements and will accept your application if your score is at least 600.