By Lauren Rosales-Shepard, Content Writer

If you want to tap into the equity built up in your home, home equity loans and home equity lines of credit (HELOCs) are two of the most popular, widely-known options available. You’ve probably heard of them–and you’ve probably also wondered, what exactly are the differences between them? After all, even their names are similar!

In this blog, we’ll dive into the ins and outs of both HELOCs and home equity loans to help you learn more about each one and discover which option might be a better fit for you.

Home Equity Loan

A home equity loan is a type of loan in which a homeowner borrows money using the equity in their home as collateral. Because that collateral reduces the risk for the lender, home equity loans can sometimes have lower interest rates than credit cards, or unsecured personal loans. Of course, however, that collateral also increases the risk for the homeowner themselves–if they fail to repay the loan according to the agreed-upon terms, the lender may have the right to foreclose on the property to recover the outstanding debt!

Here are the basics of how a home equity loan works:

1. Loan Application: You can apply for a home equity loan from a lender, just as you would other types of loans. The lender will review your credit history, income, and other financial factors to determine your eligibility–see the list below for more details.
2. Appraisal: Often, the lender will require an appraisal of your home to ascertain its current market value. This step helps establish the maximum loan amount for which you can qualify, based on your equity.
3. Loan Approval: If your application is approved, the terms of the loan, including the interest rate, repayment period, and monthly payments, are established at this stage. Subsequently, you'll receive a lump sum of money to use however you’d like.
4. Repayment: Typically, home equity loans have fixed interest rates and monthly payments; the latter usually includes both the principal plus interest. The borrower repays the loan over a set period, often with a fixed term, such as 10 or 15 years.
5. Collateral: It is imperative to remember that a home equity loan uses your house as collateral! If there is a hitch in your repayment plans, you may be at risk of losing your home to foreclosure. Remember to always alert your lender if you foresee any problems with making a payment on time.

Though eligibility criteria can vary between lenders–so definitely do your homework and research multiple options!--there are some common factors that most lenders consider when determining whether a homeowner qualifies for a home equity loan. Such factors include:

• Sufficient Equity: Lenders typically require a minimum amount of equity, often around 15% to 20% of the home's current market value. (The calculation involves subtracting the outstanding mortgage balance from the home's appraised value.)
• Credit Score: While specific credit score requirements vary by lender, a higher credit score generally improves your chances of approval and may result in better interest rates.
• Debt-to-Income Ratio: This ratio compares your monthly debt payments to your gross monthly income. A lower debt-to-income ratio is typically more favorable to lenders, as they won’t fret at your ability to make your monthly payments to them.
• Stable Income: A consistent employment history and proof of income through pay stubs, tax returns, or other financial documents are typically required so that lenders can be confident that you won’t miss any payments.
• Loan-to-Value Ratio: The loan-to-value (LTV) ratio compares the loan amount to the home's appraised value. Lenders often have maximum LTV ratios, and a lower ratio indicates less risk for the lender.
• Credit History: In addition to your credit score, lenders assess your credit history. A history of responsible credit use and timely payments can strengthen your application.

Pros of Home Equity Loan

There are several benefits of home equity loans, such as:

• Lower Interest Rates: Home equity loans often come with lower interest rates compared to other forms of borrowing, such as personal loans or credit cards. This is because the loan is secured by the equity in your home, making it less risky for lenders.
• Fixed Interest Rates: Many home equity loans have fixed interest rates, providing predictability and stability for borrowers. With a fixed rate, your monthly payments remain consistent throughout the loan term, making it easier to budget.
• Lump Sum Payment: Home equity loans typically provide a lump sum of money upfront. This can be advantageous for specific purposes, such as funding a major home improvement project, consolidating high-interest debts, or covering large expenses with a one-time payment.
• Flexible Use of Funds: Borrowers can use the funds from a home equity loan for various purposes, including home renovations, education expenses, debt consolidation, or other significant expenses. The flexibility allows homeowners to address specific financial needs.
• Longer Repayment Terms: Home equity loans often come with longer repayment terms compared to unsecured loans, giving borrowers more time to pay off the debt. This can result in lower monthly payments, making it more manageable for some homeowners.
• Lower Closing Costs: Often, home equity loans have lower closing costs than refinancing a mortgage. This is because it is a more simplified process with, sometimes, fewer third parties involved; plus, there is no need to pay off your first mortgage.

Cons of Home Equity Loan

• Risk of Foreclosure: We’ve said it before and we’ll say it again: one of the significant drawbacks of a home equity loan is the risk of losing your home if you are unable to make the required payments! Since your home serves as collateral for the loan, the lender may have the right to foreclose on the property in the event of default.
• Added Debt: A home equity loan adds a new debt obligation on top of your existing mortgage. It’s imperative that the borrower be sure of their ability to manage the additional debt, and to use the funds wisely.
• Interest Costs: While the interest rates on home equity loans can be lower than other forms of borrowing, the overall interest costs can still be substantial, especially over the loan's term if there is a long repayment period.
• Variable Interest Rates (in some cases): While many home equity loans have fixed interest rates, some may have variable rates. Variable rates can increase over time, leading to higher monthly payments and potentially greater overall interest costs.
• Closing Costs: While home equity loans may have lower closing costs than refinancing, there are still costs involved, including application fees, appraisal fees, and other charges. Borrowers should be aware of these upfront costs.
• Second Lien Position: Home equity loans are usually in a second lien position, meaning they are secondary to the primary mortgage. In case of financial distress or foreclosure, the primary mortgage is paid off first, potentially leaving less for the home equity loan.

Home Equity Line of Credit (HELOC)

A HELOC is a type of revolving credit that allows homeowners to borrow against the equity in their homes. Unlike a traditional home equity loan, which provides a lump sum of money upfront, a HELOC provides a line of credit that can be accessed as needed over a specified draw period. The draw period is typically 5 to 10 years, during which borrowers can use the funds, and it is followed by a repayment period.

Briefly, here’s how a HELOC works:

1. Assessment of Eligibility: Lenders evaluate the homeowner's eligibility based on factors such as credit score, income, debt-to-income ratio, and the amount of equity in the home.
2. Application: Homeowners submit an application for a HELOC with a typical lender. The application includes information about the property, the homeowner's financial situation, and the requested credit limit.
3. Credit Check: The lender conducts a credit check to assess the borrower's creditworthiness. Typically, a higher credit score will improve the likelihood of approval and could lead to more favorable terms.
4. Appraisal: It’s likely the lender will require an appraisal or property valuation to determine the current market value of the home and, therefore, the amount of equity available for borrowing.
5. Approval: Upon approval, the lender issues a commitment letter outlining the terms and conditions of the HELOC, including the credit limit, interest rates, draw period, and repayment period.
6. Closing: Closing procedures for a HELOC may involve signing various documents, similar to the closing process for a mortgage. At this stage, the borrower will typically pay the closing costs, including application fees, appraisal fees, and other charges.
7. Receiving Access to Funds: Once the HELOC is established, homeowners gain access to the line of credit. They can use checks, a debit card, or online transfers to access funds as needed, up to the approved credit limit.
8. Draw Period: The draw period is exactly what it sounds like–borrowers can borrow and repay funds from the HELOC. Minimum monthly payments during this period usually cover only the interest on the outstanding balance, and the period is usually 5-10 years.
9. Repayment Period: After the draw period ends, the HELOC enters the repayment period (typically 10 to 20 years). Homeowners can no longer borrow from the line of credit, and monthly payments include both principal and interest.

Not all HELOC lenders are created equally–which is to say, their eligibility criteria will vary. That said, there are some key criteria that are typically considered:

• Sufficient Equity: Lenders usually require a minimum amount of equity in the home to qualify for a HELOC. The equity is calculated by subtracting the outstanding mortgage balance from the current market value of the home.
• Credit Score: A good credit score is important! While specific credit score requirements vary by lender, a higher credit score generally improves the likelihood of approval and could lead to better terms, too.
• Debt-to-Income Ratio: This compares the borrower's monthly debt payments to their gross monthly income. A lower debt-to-income ratio is typically more favorable to lenders.
• Stable Income: A verifiably stable income is key; lenders may require proof of income through pay stubs, tax returns, or other financial documents.
• Loan-to-Value Ratio: The loan-to-value (LTV) ratio compares the credit limit of the HELOC to the home's appraised value. Lenders often have maximum LTV ratios, and a lower ratio is generally more favorable.
• Credit History: In addition to the credit score, lenders consider the borrower's credit history. A history of responsible credit use, timely payments, and a lack of significant negative marks can strengthen the application.

Pros of a Home Equity Line of Credit

There are several benefits to a HELOC:

• Flexibility in Borrowing: Borrowers can access funds as needed during the draw period, up to the approved credit limit. This flexibility can be beneficial for ongoing (like renovation projects) or variable expenses.
• Interest-Only Payments during Draw Period: During the draw period, borrowers are usually required to make minimum monthly payments that cover only the interest on the outstanding balance.
• Only Pay Interest on Amount Borrowed: Borrowers are only charged interest on the amount they have borrowed, not the entire credit limit. In other words, if you only actively borrow a small amount, you’re only paying the interest on that small amount.
• Revolving Credit: Similar to a credit card, a HELOC operates as a revolving line of credit. Borrowers can borrow, repay, and borrow again during the draw period as long as they stay within their credit limit.
• Potential Tax Deductions: In some cases, the interest paid on a HELOC may be tax-deductible, depending on the purpose of the loan and applicable tax regulations. It's advisable to consult with a tax professional to understand the specific implications for your situation.
• Use for Various Purposes: Borrowers have the flexibility to use the funds based on their financial needs, whether that’s for renovations, debt consolidation, etc.
• Draw Period Extension Option: Some HELOCs may offer the option to extend the draw period or convert the remaining balance to a fixed-rate loan at the end of the draw period, providing additional flexibility.

Cons of Home Equity Line of Credit

While there are certainly benefits to a HELOC, there are also several potential drawbacks:

• Variable Interest Rates: Many HELOCs have variable interest rates, which means the interest rate can fluctuate based on market conditions. This variability can lead to unpredictable changes in monthly payments and potentially higher costs if interest rates rise, making it difficult to make a financial plan.
• Risk of Foreclosure: As with any home-secured loan, including HELOCs, there is a risk of foreclosure if the borrower is unable to make the required payments, because your home is used as collateral.
• Closing Costs and Fees: While HELOCs typically have lower closing costs than mortgages, there are still fees associated with opening the line of credit, including application fees, appraisal fees, and annual fees.
• Minimum Draw Requirements: Some HELOCs may have minimum draw requirements, meaning borrowers must take out a minimum amount when accessing funds. This can be a disadvantage for those who only need a small amount of money, or just want to use the HELOC as an in-case-of-emergency resource.
• Interest-Only Payments: While interest-only payments during the draw period can seem like a benefit, they can also be a problem for borrowers who are not actively repaying the principal. Such a structure may result in a large balloon payment at the end of the draw period and cause sticker shock.
• Potential for Overspending: The flexibility of a HELOC can lead to the temptation to overspend, especially if the funds are used for non-essential expenses. Without careful budgeting and financial discipline, borrowers may find themselves with higher debt than anticipated.

Key Differences Between Home Equity Loan & HELOC

Obviously, there are several similarities between a home equity loan and a home equity line of credit. Understanding their differences can help you decide which is a better fit for your circumstances and your future plans.

Fixed vs. Variable Interest Rate

Typically, home equity loans have fixed interest rates; HELOCs often have variable interest rates. A fixed interest rate does not change throughout the term of the loan, whereas a variable interest rate is at the mercy of market conditions and could therefore increase during the course of the HELOC.

Installments vs. Revolving Debt

A home equity loan provides a lump sum of money upfront, and the borrower repays the loan through fixed monthly payments over a specified term. Alternatively, a HELOC operates as a revolving line of credit, allowing borrowers to access funds as needed during a draw period. The repayment period follows, during which borrowers cannot borrow further and must repay the outstanding balance.

Single vs. Ongoing Expenses

Homeowners often utilize a home equity loan to pay for a single big expense, like debt consolidation. Those who opt for a HELOC might choose that format for its flexibility, wherein borrowers can choose when and how much to borrow; this can be useful for ongoing projects like home renovations.

Which Is Better: A HELOC or Home Equity Loan?

This is the burning question!

When a Home Equity Loan is Better

• Fixed Expenses with a One-Time Need:If you have a specific, one-time expense with a known amount, such as a home renovation project or debt consolidation, a home equity loan might be preferable. With a home equity loan, you receive a lump sum upfront, and the fixed interest rate and predictable monthly payments can be advantageous for budgeting.
• Preference for Fixed Interest Rates: On that note, home equity loans typically offer fixed interest rates, which provides stability and predictability in monthly payments. If you prefer the security of a fixed rate and want to avoid the potential fluctuations associated with variable rates in a HELOC, a home equity loan may be a better choice.
• First Lien Position for Additional Security: Home equity loans are typically in the first lien position, making them the primary lien on the property. If maintaining the primary position for additional security is important to you, a home equity loan might be preferable.

When a HELOC is Better

• Variable and Ongoing Expenses: If you have ongoing or variable expenses, such as continuing home improvement projects, education expenses, or unpredictable medical costs, a HELOC provides flexibility because you can draw funds as needed.
• Emergency Fund or Financial Safety Net: A HELOC can serve as a financial safety net or emergency fund, as you have access to funds when needed but only pay interest on the amount borrowed.
• Preference for a Revolving Line of Credit: The style–a revolving line of credit similar to a credit card, where you can borrow, repay, and borrow again– may better suit your preferences compared to a home equity loan with a fixed amount.

An Alternative to Home Equity Loans & HELOCs

Both home equity loans and HELOCs entail monthly payments and interest rates. However, there is an alternative that doesn’t: a Unison equity sharing agreement.

With an equity sharing agreement from Unison, you can obtain a percentage of your home’s current value in cash in exchange for a percentage of its future change in value either a) in up to 30 years or b) at the time of sale. Like we said, Unison neither requires monthly payments nor accrues interest; that’s the main (and, we’d argue, most exciting) way that it differs from home equity loans and HELOCs. If you’re perplexed or concerned about fixed versus variable interest rates, you can eschew the question altogether with an equity sharing agreement from Unison.

Get a free estimate today, with no obligation or effect on your credit!


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