HELOC vs. home equity loan: Which is best for me?

Lenders may let you borrow up to 85% of your equity in your home with a loan or credit line depending on factors including your credit history, debt-to-income ratio and the value of your home. Your home equity is calculated by subtracting the debt you owe on your house from your home’s value.

So if both options involve borrowing against the value of your house, what’s the difference between a home equity line of credit and a home equity loan?

Home equity loans, which are sometimes called second mortgages, are a type of installment loan. The lender gives you a lump sum that you pay back in monthly installments until the loan is paid off.

Home equity lines of credit, or HELOCs, are a type of revolving credit, similar to a credit card. The lender gives you a credit limit to draw from, and you’ll pay back the amount you use plus interest.

Let’s take a look at factors you’ll want to consider, from interest rates and fees to monthly payments and fund disbursement, if you’re thinking about a HELOC versus a home equity loan.

HELOC vs. home equity loan: What’s the difference?

Here are some things you’ll want to consider before applying for a HELOC or home equity loan.

How interest works

Home equity loans usually have a fixed interest rate, which means your rate and payments stay the same throughout the life of the loan.

HELOCs typically have a variable interest rate, which means the rate can change based on a market index like the prime rate. Some lenders may offer a lower introductory rate for a short time before the rate begins to adjust — and possibly increase.

HELOCs are required to have caps that limit how much your rate can increase. Make sure to check the terms of your credit line so you know what that cap is before you take out a HELOC.

Interest you pay on a home equity loan or HELOC may be tax deductible if it’s used to improve or repair a qualifying existing home. Interest isn’t tax deductible if you use the loan or credit line for personal expenses like paying off student loan debt. Speak with a tax professional before filing to see if you’re eligible for a tax deduction.

Fees

Home equity loans can carry the same fees you encounter when purchasing a home, including application fees, origination fees, appraisal fees and other closing costs.

HELOCs may also have application fees, appraisal fees and additional closing costs. Plus, you may be charged an annual membership fee and a transaction fee each time you withdraw money. An inactivity fee or early termination fee may also apply if you don’t use the credit line enough or close it early.

Monthly payment requirements

If you have a fixed interest rate on a home equity loan, which is typical, you should be able to predict your monthly payments and calculate if it makes sense for your budget.

HELOCs may have a minimum payment that’s due every month, but the amount may not be enough to pay off your credit line. Some lenders may even allow you to make interest-only payments. Be careful though: Interest-only payments can result in a balloon payment, which is one large principal payment that’s due at the end of the repayment term.

Repayment terms

Home equity loans have fixed repayment terms. You get the repayment schedule at the beginning of your loan contract and make monthly payments until the end of the term.

With HELOCs, lenders usually give you a draw period where you’re able to take money from your credit line. The draw period is followed by a repayment period where you must pay the money back, either in installment payments over a period of time or as a lump sum. In some cases, you may be able to renew the credit line so you can continue borrowing money.

How disbursement works

If you get a home equity loan, your lender will disburse your money in one lump sum.

With a HELOC, disbursement happens as you request money. Your lender may give you a credit card or special checks to withdraw funds.

Is a HELOC or a home equity loan right for me?

The right way for you to borrow from home equity depends on your financial situation and goals. To help you figure it out, we’ve put together a list of some scenarios where you may want to choose one over the other.

When to choose a HELOC

HELOCs may be the way to go when you need flexibility to access cash for ongoing expenses.

• Education costs — Withdrawals from your HELOC can pay for ongoing education expenses such as books and course materials if you or your child is attending school.
• Events or travel — A HELOC can help you pay for ongoing bills from vendors, hotels and service providers if you’re hosting a wedding or planning a special trip.
• Ongoing home improvement projects — If you’re renovating a house in phases, it might make sense to turn to a HELOC. You could renovate your kitchen in one phase and your bathrooms in another, for example.

When to choose a home equity loan

Home equity loans are likely the better choice when you need a set amount of money instead of an open-ended credit line.

• Debt consolidation — A lump sum from a home equity loan can be used to consolidate high-interest debt sitting on different credit cards.
• Emergency bills — If your car breaks down or your water heater fails, a lump sum from a home equity loan can cover the bill from your mechanic or plumber.
• Major purchases — A lump sum from a home equity loan can help pay for major purchases like an engagement ring.
• Home renovation — If you’re planning to renovate your home in one push and know the amount you’ll need, a home equity loan may make more sense than a HELOC.
• Medical treatments — A home equity loan can pay for medical and dental procedures such as fertility treatments or veneers.

What’s next?

If you’re deciding between a HELOC and home equity loan, the first step is examining your budget to see what you can afford. Borrowing from home equity isn’t a decision you should make lightly since failing to make payments and defaulting on the loan could result in losing your home.

If you’re thinking about borrowing for a major purchase that’s not a necessity, consider saving up all or a portion of the cost to limit the amount of new debt you’re taking on.

When you’re ready to borrow, shop around with multiple lenders, including banks, credit unions and online lenders, to compare HELOC and home equity loan options. Interest rates and fees can vary from one lender to another, and price shopping allows you to weigh options before finalizing your decision.