HELOC vs. Home Equity Loan: Pros & Cons

You’ve put a lot of time and money into your home over the years. But did you know that in the process of maintaining your property and paying your mortgage each month, you’ve accumulated valuable equity in your home? And that you can borrow money using that equity as collateral?

With a home equity line of credit (HELOC) or a home equity loan, you can access a portion of the equity in your home to help pay for things like home improvements, college tuition, or unforeseen expenses. Featuring lower annual percentage rates than credit cards and personal loans plus potential tax advantages, it’s a smart way to borrow.

There are two types of home equity loan products available to consumers: a home equity line of credit and a home equity loan.


What is a Home Equity Line of Credit?

A home equity line of credit is a variable rate, revolving line of credit that’s accessed as needed (much like a credit card). Interest-only payments based on the outstanding line amount are required during the draw period, the window of time you have access to the line. Once the draw period ends, access to the line is closed and principal and interest payments for the repayment period begin. 
 

Pros

    • Interest-only payments required during the draw period
    • Can access available funds as needed
    • Potential tax advantages*

Cons

    • Variable interest rate (during the draw period) could mean higher repayment costs
    • Payments vary based on prevailing interest rates and line usage
    • Your home is used as collateral and could be at risk of foreclosure if you default on the loan.
*Consult a tax advisor or attorney regarding your personal situation.


What is a Home Equity Loan?

A home equity loan is a fixed-rate, fixed-term loan. You receive the requested loan proceeds up front in a lump sum and then make fixed payments of principle and interest for the term you select.
 

Typically speaking, a home equity line of credit is ideal for homeowners who want the flexibility to pay for expenses as needed, whereas a home equity loan is ideal for financing a one-time expense that has a predetermined cost such as a car, a wedding, or a vacation.

Pros

    • Fixed interest rate for the entire loan term
    • Fixed payments
    • Potential tax advantages*

Cons

    • Cannot access funds as needed (lump sum distribution only)
    • Principal and interest payments required (no interest-only payment option)
    • Your home is used as collateral and could be at risk of foreclosure if you default on the loan. 
*Consult a tax advisor or attorney regarding your personal situation.
 
 

HELOC vs. Home Equity Loan
At-a-Glance


 HELOC Home Equity Loan
Interest Rate Variable Fixed
Draw Period Yes No
Repayment Period Yes Yes
Payments

Interest-only Payments During Draw Period; Principle and Interest Payments During Repayment Period

 Fixed Payments Only
Maximum Loan to Value (LTV) 80% 80%
Minimum Loan Amount $10,000 $10,000


What is Home Equity and How is it Calculated?

Home equity is not simply the appraised value of your home minus the amount you owe on it. For example, if your home’s appraised value is $400,000 and you have mortgage debt of $250,000 on it, you might think you have $150,000 in equity to borrow ($400,000 - $250,000 = $150,000).  However, when borrowing against your home, your total loan amount cannot exceed a predetermined percentage of the home’s appraised value. For most home equity loans and lines that percentage is 80% of the home’s value.

Therefore, in this example you would need to take the appraised value of the home, multiply it by 80% and then subtract the outstanding mortgage balance  ($400,000 x 80% - $250,000 =$70,000). So, in this example $70,000 would be the maximum home equity loan amount that could be taken.


What is 'Loan-to-Value (LTV)' and How is it Used?

Most home equity loan products have a maximum “Loan-to-Value” or “LTV” ratio, which means the combined balance of your current mortgage and your home equity line or loan cannot exceed a predetermined percentage of the home’s appraised value. 

Using the example of a home appraised at $400,000, and assuming an LTV of 80%, the maximum home equity line or loan amount would be $70,000. The combined amount of your existing mortgage ($250,000) plus the new home equity loan ($70,000) is $320,000, which is 80% of the home’s $400,000 appraised value, or 80% loan-to-value.


Review Your Options Carefully.

Before you apply for any type of credit, it’s always a good idea to evaluate the pros and cons. First and foremost, make sure the cost of repaying your line or loan fits within your current and future budgets. You should also fully understand the benefits each type of loan provides and determine which loan type best suits your borrowing needs. Remember, your personal residence is being used to guarantee the loan, so plan and borrow wisely.

Ready to Get Started?

Interested in learning more? Click here for more information about home equity lines of credit and home equity loans at Florence Bank.