Your home doesn’t have to just be where you live — it’s also an asset that can give you substantial borrowing power. When you take out a home equity loan or home equity line of credit (HELOC), you can borrow money using the equity you’ve built as collateral.
You can use the money for just about any purpose, too — which gives you a lot of flexibility. Whether you have a home improvement project to cover or you want to pay off high-interest debt, either option could help you fund your goal.
However, there are pros and cons to borrowing against the value of your home. So find out whether a HELOC or home equity loan is right for you and how to get one.
HELOC vs. home equity loan
HELOCs and home equity loans are both considered second mortgages that are secured by your home. Both typically offer lower interest rates compared to unsecured forms of borrowing because your home secures the loan.
With both types of loans, the amount you can borrow is based on your home equity, which is the difference between your home’s value and your mortgage balance. So if your home is worth $400,000 and you owe $140,000 on your home loan, for example, then you own $260,000 in equity.
The main difference between the two is how you receive the money and repay it. HELOCs provide access to a revolving line of credit, usually with a variable interest rate, while you receive a home equity loan as a lump sum and repay it in installments at a fixed rate.
How much can I borrow?
With both HELOCs and home equity loans, lenders usually allow you to borrow up to 80% or 90% of your home’s value, minus the mortgage balance. To calculate your potential loan amount, you’ll need to know your home’s current market value, the balance on your home loan and the maximum loan-to-value ratio allowed by your lender.
Example: Let’s say your home is worth $400,000, your mortgage balance is $140,000 and your lender allows a maximum LTV ratio of 85%. Here’s how to calculate how much you can borrow using a HELOC or home equity loan:
Multiply your home’s value by the lender’s LTV ratio.
$400,000 x 0.85 = $340,000.
This shows you how much you can finance through both your first and second mortgages.
Subtract your first mortgage balance.
$340,000 – $140,000 = $200,000.
The result — $200,000 in this example — is how much you can borrow if you meet the lender’s eligibility requirements.
What is a home equity line of credit (HELOC)?
A HELOC is a line of credit that’s secured by the value of your home. It works like a credit card, so you can borrow up to a specified limit and either pay down the balance or make interest-only payments.
You can tap the line of credit as needed during a “draw period” that usually lasts 10 to 15 years. Then you enter a repayment phase of 15 to 20 years. HELOCs typically come with variable interest rates, but some lenders allow you to convert some or all of your balance into a fixed-rate loan.
Pros of a HELOC
- Potential savings: Borrowing only what you need can help you manage your budget and potentially save money if interest is charged on a smaller balance.
- Payment flexibility: You typically have the option of withdrawing money as needed during the draw period and making interest-only payments. If any balance remains at the end of the draw period, you can pay it down during the repayment phase.
- Interest rate options: Some HELOC lenders allow you to convert some or all of your withdrawals to a fixed-rate loan.
- Lower APRs: Interest rates on HELOCs are usually lower than some unsecured forms of lending, such as personal loans and credit cards.
- No restrictions: You can use your HELOC funds for any purpose.
- Potential tax deductions: Based on the size of your home loan and when you took it out, you may be able to deduct the interest paid on a home equity line of credit.
Cons of a HELOC
- Risking your collateral: A HELOC is a loan that’s secured by your home. If you fall behind on payments, the lender may foreclose on your property.
- Interest rate fluctuations: Many HELOCs come with variable interest rates, which may go up or down based on the overall market. If your rate increases, you may wind up with larger monthly payments and higher interest costs.
- Draining your equity: Borrowing against the value of your home depletes the equity you’ve built it. The equity generally replenishes as you pay down your balance or invest the funds into home improvement projects, but it may take time.
What is a home equity loan?
A home equity loan is an installment loan that’s secured by the value of your property. You receive the funds in one lump sum upfront and repay it over time, usually five to 20 years. Home equity loans typically come with fixed interest rates, so your payments are predictable for the life of the loan.
Pros of a home equity loan
- Fixed payments: A home equity loan is an installment loan with a fixed interest rate, so you’ll know your monthly payments upfront. The predictable payments can help you manage your budget and understand exactly how much interest you pay over time.
- Lower APRs: Interest rates on home equity loans are usually lower because it’s a secured form of lending.
- Few restrictions: You can use the money from your home equity loan for any purpose.
- Potential tax deductions: Based on the size of your home loan and when you took it out, you may be able to deduct the interest paid on a home equity loan.
Cons of a home equity loan
- Risking your collateral: Like a HELOC, a home equity loan is secured by your house. So you risk losing your property if you have trouble making payments on the second mortgage.
- Draining your equity: Also like a HELOC, a home equity loan takes away from the equity you have available.
- Credit does not replenish. Once you use the loan funds, you won’t be able to borrow more unless you reapply for another loan. This differs from a HELOC, which replenishes every time you pay down the balance during the draw period.
Qualifying for a HELOC or home equity loan
The qualification requirements for a HELOC and home equity loan are similar. You’ll usually need:
- Significant equity in your home: You can borrow up to 80% or 90% of your home’s value, minus your mortgage balance.
- Good to excellent credit: A good to excellent credit score usually ranges between 670 and 850, though the minimum requirement might vary from one lender to the next.
- A low debt-to-income (DTI) ratio: Your DTI ratio shows lenders how much of your monthly income goes toward debt payments. Having a lower DTI ratio generally allows you to qualify for a loan because you have room in your budget to make payments.
- To meet other eligibility criteria: Lenders might also consider your employment status, income and cash reserves as qualifying factors.
How to apply for a HELOC or home equity loan
- Compare lenders. Check out a mix of banks and credit unions, and ask about maximum loan amounts, interest rates, estimated monthly payment, fees and closing costs, eligibility requirements, and an estimated closing timeline.
- Apply for the loan or line of credit. Once you choose a lender, you’ll typically fill out an application, agree to a hard credit pull, and provide documents that show how much you earn.
- Go through underwriting. This part of the process may take a few weeks. The lender will review your documents, verify your income, and order an appraisal to check your home’s value.
- Close on the loan. On closing day, you’ll read and sign the loan papers and receive the funds.
When to choose a home equity loan vs. a HELOC
When you’re considering a home equity loan vs. HELOC, consider how you’ll use the funds and whether you want predictable payments and a set payoff timeline.
“A HELOC may be a better choice for those who need a more flexible option, as it allows for access to credit over a period of time and can be used as needed,” says Michael Collins, a chartered financial analyst and CEO of WinCap Financial. “However, if you need a large sum of money upfront and you know you’ll be able to pay it back in a set period of time, a home equity loan may be the better choice.”
Alternatives to a HELOC or home equity loan
Tapping your home equity is just one way to borrow money. Here are some other options to consider.
Personal loan
These unsecured loans may range from $500 to $50,000 or more. You receive the money as a lump sum, then repay it in installments over the course of several years. Many home equity lenders set your minimum loan at $10,000 or more, so a personal loan may be a good alternative if you need to borrow a relatively small amount or you’re uncomfortable using your home as collateral.
Cash-out refinancing
With this type of mortgage refinance, you take out a mortgage for more than you currently owe. Then, you pay off the original home loan and keep the rest as cash after subtracting any closing costs. Cash-out refinances may be a good option if you can get a good interest rate, but you’ll need to calculate the overall interest you pay to make sure you come out ahead.
Credit card
A credit card gives you access to a revolving line of credit where you can make purchases, take cash advances, and transfer balances up to a prespecified limit. That limit replenishes every time you pay down the balance.
A credit card may be a good alternative to a home equity product if the credit line is high enough and the interest charges won’t overwhelm your finances. Look for a card that comes with a 0% introductory annual percentage rate (APR). If you pay off the balance within the introductory time frame — usually 12 to 21 months — you’ll avoid paying interest altogether.
