HELOC (Home Equity Line of Credit) and Home Equity Loan: Comparing Your Options

One of the biggest perks of homeownership is the ability to build equity over time. You can use your equity to secure low-cost funds in the form of a second mortgage—either a one-time home equity loan or a revolving home equity line of credit (HELOC). There are advantages and disadvantages to each of these types of credit, so it's important to understand how they work before you proceed. You may also have other options that are worth exploring.

HELOCs and Home Equity Loans: The Basics

Home equity loans and HELOCs both use the equity in your home—that is, the difference between your home's current value and how much you still owe on your mortgage—as collateral. Because they are secured by that collateral, lenders are willing to offer home equity loans at very competitive interest rates—usually close to those of first mortgages. Compared with unsecured borrowing sources, such as credit cards, you'll be paying less in financing fees for the same loan amount.

However, there's a significant downside to using your home as collateral. As with a first mortgage, lenders will place a lien on your home, giving them the right to seize and sell it if you fail to make payments. The more you borrow against your house or condo, the more you're putting yourself at risk.

HELOC and Home Equity Loan Pros and Cons

As with any type of borrowing, HELOCs and home equity loans have upsides and downsides.

How Much Can You Borrow?

Banks underwrite second mortgages much like other home loans. They have guidelines that dictate how much they will lend (and whether they will offer you a loan at all), based on the value of your property and your personal creditworthiness.

In making their determination, lenders will calculate a combined loan-to-value (CLTV) ratio. That ratio measures the value of all the loans that secure the home, including first and second mortgages, against what the home is worth.

Here's an example. Suppose you're working with a bank offering a maximum CLTV ratio of 80%, and your home is worth $300,000. If you currently owe $150,000 on your first mortgage, you may qualify to borrow an additional $90,000 in the form of a home equity loan or HELOC. The calculation is $300,000 x 0.80 = $240,000 - $150,000 = $90,000.

Here is more about how home equity loans and HELOCs work:

How Home Equity Loans Work

A home equity loan comes as a lump sum of cash. It can be a good option if you need the money for a one-time expense, such as a kitchen renovation or a wedding. These loans usually offer fixed rates, so you know precisely what your monthly payments will be when you take one out.

Home equity loans usually aren't the answer if you only need a small infusion of cash. Though some lenders will extend loans for $10,000, many won't give you one for less than $35,000. What's more, you have to pay many of the same closing costs associated with a first mortgage, such as loan-processing fees, origination fees, appraisal fees, and recording fees.

Lenders may also require you to pay points—that is, prepaid interest—at closing time. Each point is equal to 1% of the loan value. So on a $100,000 loan, one point would cost you $1,000.

Points lower your interest rate, which might actually help you in the long run. Still, if you're thinking about paying off the loan early, that upfront interest doesn't work in your favor. If you think that might be the case, you can often negotiate with your lender for fewer or even no points.

How HELOCs Work

HELOCs work differently from home equity loans. They are a revolving source of funds, much like a credit card, that you can borrow from as you choose as long as you don't exceed your assigned credit limit.

Most lenders offer a number of ways to access those funds, whether it's through an online transfer, writing a check, or using a credit card linked to your account. Unlike home equity loans, HELOCs tend to have few, if any, closing costs, and they usually feature variable interest rates—though some lenders offer fixed rates for a certain number of years.

There are pros and cons to the flexibility that these loans offer. On the plus side, you can borrow against your credit line at any time, and you won't owe interest on the untapped funds. In that way, it can be a useful source of ready cash in an emergency, such as if you lose your job or face a big medical bill (as long as your bank doesn't require any minimum withdrawals before then).

The biggest downside, again, is that your home serves as collateral for a HELOC. If you're unable to repay it for any reason, you risk losing the home to foreclosure.

HELOC Draw and Repayment Periods

Most home equity credit lines have two phases. First is a draw period, often 10 years, during which you can access your available credit as you choose. Typically, HELOC contracts only require you to make small, interest-only payments during the draw period, though you may have the option to pay extra and have it go toward the principal.

After the draw period ends, you can sometimes ask for an extension. Otherwise, the loan enters the second phase, repayment. From here on out, you can no longer access additional funds and you must make regular principal-plus-interest payments until the balance is paid down to zero. Most lenders have a 20-year repayment period after a 10-year draw period.

Once the repayment period begins, your required payments can almost double. For example, payments on an $80,000 HELOC with a 7% annual percentage rate (APR) would run about around $470 a month during the first 10 years when only interest payments are required, then shoot up to around $720 a month when repayment kicks in.

That can result in payment shock for many unprepared HELOC borrowers and even lead to default and foreclosure if the borrower can't afford the new payments.

Home Equity Loans and HELOCs vs. Refinancing

Second mortgages aren't the only way to tap the equity in your home and obtain some extra cash. You can also do what's known as a cash-out refinance, in which you take out a new and larger loan to replace the original mortgage. After paying off the old loan, you can use the remaining cash for whatever purposes you have in mind.

Refinancing does have certain advantages over a second mortgage. The interest rate is generally a bit lower than that of home equity loans and if rates have dropped overall since you took out your old loan, you'll want your new primary mortgage to reflect that.

Refinances have drawbacks, too. You're taking out a new first mortgage, so closing costs tend to be higher than with HELOCs. And if refinancing means you'll have less than 20% equity in your home, you may also have to pay private mortgage insurance (PMI) premiums. PMI can usually be canceled when a borrower reaches 20% home equity.

It can be a good idea to have a loan officer run the numbers for each option, so you can decide which one might be better in your situation.

Getting a Home Equity Loan or HELOC

Loans can vary significantly from one lender to the next, so it pays to shop around. In addition to traditional banks, you can also reach out to savings and loans, credit unions, and mortgage companies.

Though it's extra work, don't talk to just one lender. Most borrowers should get at least three quotes. You might want to start with any bank or other financial institution where you already have an account. Ask if it has special rates or other incentives for existing customers.

Another option is to use a mortgage broker. They have relationships with multiple lenders and get paid by the lender you ultimately choose.

For loans under $100,000, a small community bank or credit union may offer the best deal. For larger loans ($150,000 or more), talk to local and national banks along with mortgage brokers.

Don't focus solely on interest rates. Also ask about closing fees and any other costs in order to make a fair comparison.

Negotiating for Lower Fees

Many of the fees a lender may try to charge aren't set in stone. Some lenders, for example, are willing to bend on origination fees, which cover the commission paid to the loan officer or broker. If they require you to pay points on your loan, they may be willing to haggle on that, too. But you have to ask.

In general, you'll get the best terms if you have a history of steady employment and a strong credit score. As with any loan application, it's a good idea to check your credit reports ahead of time and make sure they're free of errors that could hurt you. By law you're entitled to a free copy of your credit report at least once a year from each of the three major credit bureaus, Equifax, Experian, and TransUnion. The official website for that purpose is AnnualCreditReport.com.

If You Can't Pay Back Your Loan or HELOC

If, for whatever reason, you find that you can't pay back your home equity loan or line of credit, it isn't a foregone conclusion that you will lose your home. However, even if you avoid losing your home, you will face serious financial consequences.

Most mortgage lenders will work with borrowers who are struggling to make payments. But it's important to contact your lender as soon as possible. The last thing you should do is ignore the problem and allow it to become worse.

Some lenders will offer certain borrowers a modification of their home equity loan or line of credit. Modifications can include adjustments to the term or length of the loan, the interest rate, the monthly payments, or some combination of those. Bear in mind that extending the term of the loan will lower your monthly payments, but it may mean paying more in the end.

The Bottom Line

There may come a time in your life when access to extra cash becomes a necessity. If so, a home equity loan or HELOC could be your best option. While many consumers use these forms of credit without incident, it's worth knowing that there are also risks involved before you apply.