Home Equity Loan vs HELOC

Understanding the differences between a home equity loan and a HELOC helps you make informed financial decisions and choose the right solution for your needs. Equity is a valuable asset that comes with homeownership. This built-up value can be tapped into strategically to finance life's goals. In this article, we'll explain home equity loans and HELOCs and explore the advantages and disadvantages of each option to help you find the right option for you.

What Is A Home Equity Loan?

A home equity loan allows homeowners to tap into the equity they've built up in their home to access a lump sum of cash. This equity represents the difference between your home's current market value and the amount you still owe on any mortgages or liens. For instance, if your home is appraised at $375,000 and your remaining mortgage balance is $275,000, you would have $100,000 in home equity.

Home equity loans are sometimes referred to as second mortgages because they create an additional monthly payment obligation. They provide borrowers with a fixed-rate loan, meaning your monthly payments will remain consistent throughout the loan term. Common uses for home equity loans include home renovations, college tuition assistance, or making large purchases.

Pros and Cons of a Home Equity Loan

Before deciding if a home equity loan is the right fit for your financial goals, consider your overall financial situation. Here's a breakdown of the key advantages and potential drawbacks of home equity loans:

Pros:

Easier Qualification. Home equity loans often have less stringent qualification requirements compared to other loan options.
Predictable Payments. The fixed interest rate ensures consistent monthly payments throughout the loan term, eliminating surprises in your budget.
Longer Loan Terms. Home equity loans typically offer longer repayment periods than other loan types, providing more flexibility for managing monthly payments.
Flexible Use of Funds. Unlike some loans with specific spending restrictions, a home equity loan allows you the freedom to use the funds for various purposes.
Immediate Access to Funds. Once your loan is approved, the funds become readily available for your needs.

Cons:

Increased Monthly Obligation. A home equity loan adds another monthly payment to your existing housing costs, so careful budgeting is essential.
Risk of Foreclosure. Defaulting on your loan payments could lead to foreclosure, putting your home ownership at risk.
Full Repayment at Closing (if selling). If you sell your home before the loan is fully repaid, the outstanding balance typically needs to be settled at closing.
Limited Borrowing Power. Most home equity loans have a maximum borrowing limit, often capped at 80% of your home's value minus any existing mortgage balance.

Benefits of a Home Equity Loan from HFCU include:

Can use the equity for buying a second home.
Terms offered from 3 to 15 years.
Borrow up to 100% of available equity.
Borrow up to 133% of home equity on some home improvement only loans.
Alternative energy, renewable energy, or home energy efficiency projects could qualify for discounted rates.

What is a Home Equity Line of Credit (HELOC)?

A Home Equity Line of Credit (HELOC) functions similarly to a credit card, offering a revolving line of credit based on the equity you've built up in your home. Just like with a home equity loan, the amount you can borrow with a HELOC is determined by your available equity.

One difference between a home equity loan and HELOC is in how you borrow funds. With a HELOC, you can borrow what you need upfront, repay it over time in installments, and then tap back into the available credit line during a designated period called the draw period. During this draw period, which typically lasts around ten years, your monthly payments cover just the interest on the borrowed amount. However, you have the option to make principal payments to reduce the outstanding balance. Once the draw period ends, you enter the repayment period. During this stage, you can no longer borrow additional funds and your payments will go towards both the principal and interest until the loan is paid off in full.

HELOCs are a popular option for financing home improvement projects, but the funds can be used for a variety of purposes, including debt consolidation, educational expenses, or unexpected needs.

Pros and Cons of a HELOC

Similar to a home equity loan, a HELOC comes with its own set of advantages and disadvantages to consider. Here's a breakdown of the key benefits and potential drawbacks of a HELOC:

Pros:

Flexibility in Accessing Funds. When it comes to a home equity loan versus a HELOC, a HELOC offers more flexibility. You only borrow what you need upfront and can tap back into the available credit line during the draw period, making it suitable for ongoing expenses.
Interest Savings. You only pay interest on the amount of money you use during the draw period, not on the entire credit line. This can lead to significant interest savings compared to borrowing a lump sum.
Potentially Lower Rates. HELOCs are typically secured by your home's equity, which can qualify you for a lower interest rate compared to unsecured loan options like personal loans or credit cards.
Potential Tax Benefits. Consult with a tax advisor to see if the interest paid on your HELOC may be tax-deductible, especially if the funds are used for qualified home improvements.

Cons:

Variable Interest Rates. HELOCs have variable interest rates, which means the rate can fluctuate over time. This can make budgeting more challenging if the rate increases significantly.
Risk of Foreclosure. As with a home equity loan, defaulting on your HELOC payments puts your home ownership at risk of foreclosure.
Potential for Higher Payments Later. The lower interest-only payments during the draw period can be attractive, but be mindful that once you transition to the repayment period, your monthly payments will increase to cover both principal and interest, potentially straining your budget.
Reduced Line of Credit. In extreme cases, if home values in your area decline significantly, your lender may reduce or freeze your available credit line during the draw period.

Benefits of a Home Equity Loan from HFCU include:

Fixed rate for two years, variable for the rest of loan term.
Borrow up to 100% of available home equity.
Draw funds, pay off the balance, use it again, or keep the line open with no balance.
10-year draw, 15-year term.

Deciding Between a Home Equity Loan or HELOC?
Here's How to Get Started

Choosing the right option between a home equity loan versus a HELOC depends on your specific needs and financial goals. Once you've determined which product might be a good fit, here are two essential steps to take when applying for a home equity loan or HELOC.

Understand Your Debt-To-Income Ratio

Your debt-to-income (DTI) ratio is an important factor that lenders consider when evaluating your application for a home equity loan or HELOC. It provides a snapshot of your overall financial health by comparing your monthly debt obligations to your gross monthly income. A lower DTI ratio indicates a stronger ability to manage existing debt and take on additional payments.

Here's how to calculate your DTI ratio:

Gather Your Monthly Debt Obligations. Add up all your recurring monthly debt payments, including, but not limited to, your primary mortgage payment, student loans, car loan payments, minimum credit card payments, alimony, and child support.
Calculate Your Gross Monthly Income. This is your total income before taxes and deductions are taken out.
Divide Debt by Income and Express as a Percentage: Divide the sum of your monthly debt payments by your gross monthly income and multiply the result by 100 to express it as a percentage. For instance, if your total monthly debt payments are $1,500 and your gross monthly income is $5,000, your DTI ratio would be 30% ($1,500 / $5,000 = 0.30 x 100 = 30%).

Why Does DTI Matter? Generally, lenders prefer borrowers with lower DTI ratios, as it demonstrates a greater capacity to handle additional debt obligations associated with a home equity loan or HELOC.

Review Your Credit Score

Your credit score is a significant factor influencing your eligibility and potential interest rate for a home equity loan or HELOC. A strong credit score indicates a history of responsible credit management, making you a more attractive borrower to lenders. The higher your credit score, the more favorable the interest rate you may be offered on your home equity loan or HELOC. This can translate to significant savings over the life of the loan. In some cases, lenders may allow you to borrow a higher percentage of your home equity with a stellar credit score, but check with your financial institution for clarification.

How to Check Your Credit Score

You can access your credit report and credit score for free from various sources, including Annual Credit Report.com. It's advisable to obtain your credit report from all three major credit bureaus (Experian, Equifax, and TransUnion) to ensure accuracy.