Recently, homeowners have been turning to their equity for their financing needs.
After all, most already have a very low mortgage rate and do not want to disturb it in any way.
If they were to go the refinancing route, they would lose their old low value and end up with a much higher one.
To avoid this, they can take out a second loan instead and keep the original loan intact.
The question is: Are you going with a HELOC or a home equity loan?
How HELOCs and Home Equity Loans Are Similar
If you are like many people trying to understand the difference between a home equity line of credit (HELOC) and a home equity loan, let me help you.
There are significant differences between the two, despite sharing many similar qualities. Let’s discuss them first before we get into their differences.
First, they both often serve as secondary mortgages. And both allow you to tap into your home equity.
You can get cash from anywhere and you can do so without compromising your original mortgage.
Nothing changes about your first mortgage when you take out a second mortgage such as a HELOC or home equity loan.
And that’s a good thing if you have one of those 30% 30% mortgage rates that were available for most of the last decade.
So whichever one you choose will allow you to continue enjoying that lower rate, unlike a cash out refinance, which can pay off your old loan and create a new one.
If that makes sense, let’s move on to those three main reasons why they are different.
HELOCs are Open Lines of Credit, Home Equity Loans are lump sum payments
Now about those main differences. Another big difference is that a HELOC is an open line of credit, while a home equity loan is a closed, lump sum loan.
Let’s discuss home equity loans first because they are easy to understand. You bid for X amount of dollars and get that amount at closing.
For example, if you apply for a $50,000 home loan, you get $50,000 at closing and pay it back every month.
A one-time deal that allows you to borrow a certain amount, such as a home equity loan.
Unless it’s taken out by existing homeowners who tap their equity and use the proceeds for whatever they want, like other investments, college tuition, more expensive debt, etc.
In contrast, A HELOC works like a credit card by applying for a credit limit and borrowing as little or as much as you like.
Using the same $50,000 example, you would get a $50,000 credit limit using your home equity as collateral.
You can then borrow from it as you wish, or perhaps keep it open as an emergency line in case you need money in the future.
Also, you can borrow from it multiple times during the draw period, which is usually 10 years.
So you can borrow the entire line ($50k), pay off some of it, and borrow again during this window.
For home loans, you only get to borrow once. Simply put, a HELOC offers more flexibility, much like a credit card. While a home equity loan works like a regular loan.
Tip: Pay attention to the initial loan amount (if any), which may apply to the initial deductible or the total amount of the loan/line when comparing options.
HELOCs Have Variable Rates, Home Equity Loans Are Fixed Rate
The next big difference is that HELOCs are variable rate loans, while home equity loans are fixed rate loans.
A home loan may have a fixed rate of 9% or 10% and that is where it will stay for the duration of the loan.
It will not be subject to any rate changes, so you will enjoy the certainty of payment every month.
Additionally, because a home equity loan is a lump sum loan, you will know exactly what the payment is each month. It won’t change.
Meanwhile, the HELOC is tied to the first rate, which is run by the Federal Reserve. Whenever the Fed lowers or raises rates, the prime rate will move by the same amount.
For example, the Fed recently cut rates by one-and-a-half basis points and then another quarter-point increase.
This reduced the maximum by 0.75%, so those who already had HELOCs saw their interest rate drop by that amount.
In other words, a HELOC holder with an 8% rate now has a 7.25% rate. A good deal if prices drop. But they can also go up.
Because of this uncertainty, HELOC interest rates are generally lower than mortgage rates.
Tip: The Fed is expected to continue cutting rates in 2025, so chances are HELOC rates will also drop significantly.
HELOCs come with an Interest Only Period
The final difference between these two loan products is that HELOCs offer an interest-only period.
At the time of HELOC drawdown (when you can take the money out of the credit card), the minimum payment required is usually interest only.
So you don’t need to pay back the principal (the amount you borrowed). You have to pay only half of the interest. Generally, this is an option for up to 10 years.
As a result, you can enjoy a lower monthly payment during the draw periodabout less than a comparable home equity loan, which requires full repayment from the time you move.
The good thing is that you have lower monthly payments. The downside is that you may pay more interest if you don’t pay off the loan until later.
And once the draw period is over on the HELOC, your payments will jump as your loan is amortized over the remaining term, perhaps 20 years or less.
This means that while the choice between the two may come down to income, a HELOC offers more flexibility in repayment. And early loan options.
Home loans provide peace of mind with a fixed amount, but they also require you to borrow the full amount at closing, which you may not really need. And you can’t draw on it again in the future.
To summarize, HELOCs are variable-rate, open-ended lines of credit with multiple payment options.
While a home loan is closed, it is a lump sum loan that requires payments to be paid in full including both principal and interest.
Take the time to compare the two to ensure you get the right product for your unique situation.
The final wrinkle is that some lenders now offer fixed-rate HELOCs, such as the Figure Home Equity Line, so the products are more difficult to compare.
Read on: Cash Out vs. HELOC vs. Home Equity Loans: Which Is The Best Option Now And Why?
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