HELOC vs Home Equity Loan: Pros & Cons | BiggerPockets Blog

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Choosing between a HELOC vs. home equity loan is a big decision. HELOCs have variable interest rates and home equity loans have fixed rates, but that’s not the only difference.

Check out how they compare to see which makes the most sense for your real estate business.

What Is a HELOC?

A HELOC or home equity line of credit is a second lien on your property. It’s separate from any first mortgage liens you have on it.

A HELOC works much like a credit card. You receive a credit line that you can access as you need. There isn’t a limit to how much you can withdraw, up to the credit line’s limit. HELOCs have a draw period and a repayment period.

Draw period

The draw period determines how long you can withdraw funds using a linked debit card or by writing checks. You can make interest payments or repay the borrowed principal, plus interest, during this time.

If you repay what you borrowed, you can draw funds from the credit line again until the draw period ends.

The repayment period

The repayment period begins when the draw period ends. During the repayment period, you make principal and interest payments monthly.

HELOCs have a variable interest rate, so you won’t know your payment amount from month to month as it depends on how the market performs.

What Is a Home Equity Loan

A home equity loan is also a second mortgage on the property. However, unlike a HELOC, you receive the funds in one lump sum instead of a credit line. You can use the funds however you want, even creating your own credit line by putting the funds in a savings or money market account to draw from as needed.

Fixed interest rate

Home equity loans have a fixed interest rate, unlike HELOCs. So you know from the time you sign the loan documents what interest rate you’re paying. It never changes, and neither do your monthly payments. You pay the same amount each month.

When monthly payments start

You start making monthly payments, usually on the first of the month following the loan closing. For example, if you close on May 15, your first payment will likely be due June 1. Sometimes, there may be a longer delay, and your first payment would be July 1. It depends on the lender.

Similarities and Differences Between HELOCs and Home Equity Loans

When comparing a HELOC and a home equity loan, consider the similarities and differences to determine which works best.

Similarities between home equity loan vs. home equity line of credit

There are many similarities between a home equity loan and a home equity line of credit, including the following.

• They are both second mortgages: Both are secured loans requiring collateral. The property is the collateral for both home equity loans. If you miss too many payments, you put the property at risk of foreclosure.
• Make monthly payments: You are obligated to make monthly payments to both loans unless you didn’t draw money from the HELOC. The monthly payments will differ, but if you borrow money, you must repay it.
• Potential for a fixed interest rate: Home equity loans automatically have fixed monthly payments, but some lenders allow borrowers to lock a rate on a portion of their HELOC. If you choose this option, you may freeze that part of the loan proceeds, meaning you can’t reaccess them, but you get predictability in the loan payment.
• You’ll incur closing costs: Most mortgage loans typically have closing costs. They won’t be as high as when you closed on the first mortgage, but there are closing costs you will pay.

Differences between home equity loan vs. home equity line of credit

Just as there are similarities, there are also many differences when comparing home equity loans and HELOCs, including the following:

• Interest rates aren’t the same: Home equity loans typically have a fixed interest rate, and HELOCs have a variable interest rate. As discussed above, there are circumstances where you might have a fixed monthly payment on a part of your credit line, but then you freeze it.
• Receiving funds: Home equity loans pay out funds at the closing on an investment property or after the three-day right of recission on an owner-occupied property. You can use them or save the funds in your own account, whatever you choose. Home equity lines of credit provide access to a credit line where you can draw money as needed or request a lump sum at the closing if you need cash immediately.
• Monthly payments: The home equity loan monthly payment is fixed. The interest rate never changes, and neither does your payment. Home equity lines of credit payments depend on how much money you withdrew and whether you’re making interest-only payments or paying back some of the principal during the draw period.

An example comparing the difference between a home equity loan and a line of credit

Here’s a quick example of how the payments would differ for a home equity loan vs. a line of credit.

• Loan amount: $25,000
• HELOC rate: 11.9%
• Home equity loan rate: 9.75%

A HELOC with a 30-year term (10-year draw and 20-year repayment) will have a payment of $253 per month, but that could change based on the variable interest rates.

A home equity loan for the same loan amount with a 30-year term will have a monthly payment of $214.79.

This comparison assumes you’d withdraw the entire loan principal at the closing. If you don’t use the whole credit line, your payment will be lower on the HELOC, but it can change monthly based on market rates.

Pros and Cons of HELOCs

When using home equity, a home equity line of credit has pros and cons. Here’s what to consider.

Pros

• You only pay interest on the money you withdraw. So you could have a $10,000 HELOC, but if you only have a $1,000 outstanding balance, you’d only pay interest on the $1,000.
• You can make interest-only payments. Some borrowers see this as a benefit, especially if they’re experiencing a financial situation they didn’t anticipate, such as tenants that destroyed the house or a natural disaster that requires expensive work to repair.
• You may get a fixed rate for a short period. Some lenders offer a fixed interest rate for an introductory period, much like credit card companies do to get you to take the loan. You may also be able to convert a portion of the loan balance to a fixed-rate loan if you no longer need to use it.
• You may be eligible for lower interest rates. Most credit lines secured by a property have much lower interest rates than personal loans or credit cards.

Cons

• You risk losing your home. If you miss too many payments, the lender could start foreclosure proceedings on the property.
• You could easily overspend. Having a credit line available is the equivalent of creating credit card debt. Knowing you can use the funds whenever you want can be dangerous if you aren’t financially responsible.
• You’ll have unpredictable payments. The variable interest rate makes it hard to predict your payments and budget. If the payment increases your operating expenses too much, it could decrease your profits.
• The full loan becomes due when you sell the property. If you decide to utilize your exit strategy and sell the property, the proceeds must go to the primary mortgage and second loan lender before you receive any funds.

Pros and Cons of Home Equity Loans

Home equity loans also have pros and cons. Understanding the good and bad can help determine if a home equity loan suits you.

Pros

• You’ll have fixed payments. The fixed interest rate means fixed payments for the loan term. You never have to worry about the payment changing and ruining your budget.
• You can use the funds for anything. Most lenders don’t ask why you need the funds; if they do, it usually doesn’t affect your loan approval.
• You may get better terms than other loan options. If you compare a home equity loan to credit cards or personal loans, you’ll see that you may get better terms because you receive the funds as one lump sum.

Cons

• You must make principal and interest payments immediately. Unlike HELOCs, you must make full monthly payments immediately and for the duration of the loan.
• Home equity loans often have higher closing costs. HELOCs usually cost less to close than home equity loans, which means you must have more money at closing.

How To Get a HELOC or Home Equity Loan

Fortunately, securing a home equity loan or HELOC is pretty straightforward. Once you decide which is right for your financial needs, get quotes from two to three lenders.

How to apply

Most lenders have an online application process. You’ll complete a loan application stating how much you need to borrow, how much equity you have in your home, and information about your income, assets, and home’s market value.

Qualifying for home equity loans and HELOCs

Understanding how to qualify for home equity loans and HELOCs is important. Fortunately, the guidelines are simpler than a first mortgage.

• Decent credit scores: Each lender requires different credit scores, but on average, you’ll likely need a 680+ to get the best rates and terms.
• Average debt-to-income ratio: Many lenders require a 45% or lower DTI. This means the new home equity loan or line of credit payment plus any other consumer loan payments you have don’t exceed more than 45% of your monthly income.
• Enough equity in your home: Whether you want to borrow money from your primary residence or a rental property you own, you’ll need enough equity to borrow from and leave at least 20% untouched. Many lenders will lend up to 80% to 85% of the appraised value.

Provide documentation and get a home appraisal

After applying for a home equity loan or line of credit, you must provide the lender with the necessary documentation, including:

• Pay stubs and W-2s to prove your income
• Tax returns if you’re self-employed or are using your rental income to qualify
• Bank statements to prove you have reserves
• Employer information to validate your employment
• Pay the appraisal fees to have an appraiser evaluate your home’s market value

The appraiser will compare your home to other recently sold homes, using their property values to determine the market value of the property you’re trying to borrow a home equity loan or line of credit.

Close the loan

After final approval, you close the loan and pay closing costs, as you did with your first mortgage. You’ll sign documents stating you understand your monthly payment and the obligation you’re accepting.

If you borrow a home equity loan, you’ll receive the funds at the table on any non-primary residences, and if it’s an equity line of credit, you’ll receive instructions on how to access your funds.

HELOC vs. Home Equity Loan: Which Is Best for You?

The difference between choosing a HELOC or a home equity loan is personal preference.

Choose a home equity loan if you want fixed monthly payments and need funds for one-time use. For example, if you’re paying for an emergency, medical bill, or a dream vacation, you don’t need access to the funds again. Take advantage of the fixed interest charges to pay the loan in full.

However, an equity line is better if you need a revolving loan to access the loan proceeds continually or need interest-only payments during the draw period. Just be sure you can manage the line of credit without spending needlessly. It’s also best to pay more than just the monthly interest charges.

HELOC vs. Home Equity Loan FAQs

What is the difference between a HELOC and a home equity loan?

A HELOC is a line of credit you can draw on like a credit card. You can use up to the maximum amount of the line of credit and pay interest only during the draw period if you choose. If you repay the borrowed amount, you can reuse the funds.

A home equity loan is a fixed-rate second mortgage. You receive the loan proceeds once at the closing and can use them however you want. Your payments never change on a home equity loan, and you don’t have access to reuse the funds.

Is there a downside to having a HELOC?

The largest disadvantage of a HELOC is the variable interest rate. You can’t predict your monthly payments. They can increase or decrease monthly, and you’re expected to keep up with your debts.

Is a HELOC a good or bad idea?

A HELOC can be a good idea when you need continual access to funds. For example, if you’re making home improvements, you may not know the full cost or what you’ll run into during the work. Having access to a credit line can make it easier.

Can you pay off a HELOC early?

Yes! You can pay your HELOC in full at any time. This is a good way to minimize interest charges and save money.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.