HELOC vs. Home Equity Loan: How to Choose

Both let you borrow against the equity in your home, and both put your home up as collateral. The difference is how you receive the money and how the rate behaves:

• A home equity loan pays you one lump sum at a fixed rate, with the same payment every month until it's paid off.
• A home equity line of credit (HELOC) gives you a credit limit you can draw from as needed, usually at a variable rate, and you pay interest only on what you've drawn.

Choose the loan when you know the exact amount and want a fixed payment. Choose the HELOC when the amount or timing is uncertain.

Side by side

Example 1: A kitchen renovation paid in stages

You expect a $60,000 renovation, paid to contractors over eight months. The final bill might be higher.

With a HELOC, you draw $15,000 for the deposit, more as each stage finishes, and pay interest only on what you've drawn. If the project comes in at $54,000, you never borrow the last $6,000. If it runs over, you have room left on the line.

With a home equity loan, you borrow the full $60,000 on day one and pay interest on all of it while the money sits waiting for invoices. If the project runs over, you need a second loan.

For a project like this the HELOC usually fits better.

Example 2: Paying off $40,000 of credit card debt

You want to replace high-interest card balances with a lower rate and a clear payoff date.

A home equity loan gives you $40,000 at a fixed rate. At 8.50% over 10 years the payment is about $496 a month, and it never changes. The debt is gone in exactly 120 payments.

A HELOC would work too, but an interest-only draw period makes it easy to pay only the interest and keep the debt for years. A variable rate also means the payment can rise.

Here the home equity loan's structure works in your favor. One caution applies to either option: moving card debt onto your home turns unsecured debt into debt secured by your house. If the cards fill back up, you end up with both.

How the rates compare

Home equity loan rates are fixed when you close. HELOC rates are usually the prime rate plus a margin set by the lender based on your credit and loan-to-value. When the Federal Reserve changes rates, the prime rate usually moves with it, and so does your HELOC payment.

Some lenders offer HELOCs with a low introductory rate for the first 6 to 12 months, and some let you lock part of your balance at a fixed rate. Ask what the rate becomes after the intro period and whether locking has a fee.

Costs to compare

Both products can carry closing costs. Ask each lender for:

• Origination or application fees
• Appraisal fee
• Title search and recording fees
• HELOC only: annual fees, minimum draw requirements, inactivity fees, and early closure fees if you close the line within the first few years

Some lenders advertise "no closing costs" and recover them through a higher rate or by charging them back if you close the line early.

What about a cash-out refinance?

A cash-out refinance replaces your current mortgage with a bigger one and pays you the difference. It can make sense when today's mortgage rates are at or below the rate you have now. If your current mortgage rate is lower than today's rates, refinancing means giving up that rate on your whole balance. In that case a HELOC or home equity loan, which leaves your first mortgage alone, usually costs less.

Risks that apply to both

• Your home secures the debt. Missing payments can lead to foreclosure.
• Home values can fall. If prices drop, you could owe more than the home is worth, and a lender can freeze or reduce an unused HELOC.
• Selling the home means repaying both your mortgage and the home equity debt at closing.

Sources

• CFPB: What is a home equity line of credit (HELOC)?
• CFPB: What you should know about home equity lines of credit (PDF)
• Federal Reserve: Bank prime loan rate (H.15)