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

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Whether you're trying to repair a leaky roof or obtain funds for a new small business, there may come a time when you find yourself shopping for a loan. There are many ways to borrow money, from credit cards to personal loans, although homeowners have another compelling option: borrowing against the equity in their home.

Home equity lines of credit (HELOC) and one-time home equity loans have long been popular among American consumers and with good reason. Here's what to know about a HELOC vs. home equity loan so you can decide if these products are right for you.

How does a home equity loan work?

While a line of credit and a lump-sum home equity loan have some important distinctions, they have one key similarity: In both cases, you're using the equity in your home as collateral. This means that, until you pay it back in full, the lender has a lien on your house. If you fail to make those payments, it can eventually foreclose on the property.

The equity in your home is simply the market value of the home minus any loans against the property, including the primary mortgage and any other home equity loans. For example, if your home is worth $500,000 and you owe $300,000 in home loans, you have $200,000 in equity.

The advantage of putting up collateral is that it helps protect the lender from a potential loss of money. If you fail to pay up, they can take possession of your home and likely sell it to make itself whole. Because of this security blanket, lenders are typically willing to offer lower interest rates than on unsecured loans where there's no collateral involved.

Because the value of real estate changes over time, banks typically set a maximum loan-to-value (LTV) ratio of 80% to 85%, though this threshold varies based on the lender. Assume a particular bank has an LTV of 80%. That means the total value of all loans against the home can't exceed 80% of the home's market value. In the above example, the homeowner would be limited to borrowing no more than $100,000 ($300,000 primary mortgage + $100,000 home equity loan = $400,000, or 80% of the $500,000 home value).

Lump-sum or revolving credit line

The most fundamental difference between these products is how you receive your funds and pay the lender back. A home equity loan is a one-time source of funds that you typically repay through fixed installments. A HELOC works differently in that you have the ability to borrow funds multiple times, up to a maximum amount.

In that sense, HELOCs work a lot like a credit card—albeit one with considerably lower interest rates, since it's backed by your home's value. In fact, HELOC credit cards, along with checks, are one of the primary ways borrowers can access their available credit.

However, home equity lines are different from most credit cards in that there's a time limit—usually several years—on when you can borrow. Even during this "draw period," you have to make minimum payments. When the draw period ends, the HELOC goes into the repayment period. At that point, you pay the remaining balance in a single payment or through a series of payments, depending on the loan terms.

Comparing a HELOC vs. home equity loan

Both HELOCs and home equity loans represent a relatively low-cost form of borrowing that can make them useful for larger financial needs. These may include consolidating expensive credit card debt, paying for a major expense like a medical bill or renovating your home.

The two forms of credit have certain features in common but also important differences. Here's how they compare:

Similarities

  • Rates depend on creditworthiness. Both types require applicants to go through underwriting before getting approved. Customers with better credit scores, lower debt-to-income ratios and steady employment tend to get the best interest rates.
  • Interest rates are better than most loans. Because they're backed by a tangible asset, HELOCs and home equity loans offer rates that are similar to first mortgages. They're generally substantially lower than those of credit cards or even personal loans that have no collateral.
  • You'll have to pay closing costs. Regardless of whether you apply for a home equity loan or a HELOC, you can expect to pay fees for the loan origination, property appraisal and credit report, to name a few. All told, the closing costs usually total 2% to 5% of the loan amount. Some lenders may offer no-closing-cost HELOCs, although they may place certain restrictions on your account or charge ongoing fees.
  • Borrowers take on risks. The additional lien on your home can be a daunting prospect for some borrowers. If you don't pay back the HELOC or equity loan on time, the lender may decide to foreclose on the property. A foreclosure is less likely if you're "underwater" on the second mortgage—meaning your home isn't worth enough to cover the unpaid balance—but the lender may still decide to sue you to recoup funds.
  • You may be able to deduct the interest. This is one big advantage of HELOCs and equity loans over other forms of borrowing. However, the Tax Cuts and Jobs Act of 2017 put temporary restrictions on when you can write off your interest payments, through 2026. To qualify, you need to borrow against the equity in your primary or secondary residence, and you have to use the funds to "buy, build or improve" one of those homes.

Differences

  • You have more flexibility with a HELOC. With a line of credit, you only borrow when you need the money. As a result, you're only paying back principal and interest on the amount you borrow. That's not the case with a traditional home equity loan.
  • HELOCs usually have adjustable rates. As with credit cards and other variable-rate loans, they can go up when interest rates go up economy-wide and vice versa. Home equity loans, on the other hand, tend to come with fixed rates. Some borrowers prefer having that predictability.
  • Home equity loans offer lower initial rates. Because banks take on added risk when they offer fixed-rate equity loans—since it's possible that general interest rates could go up—they charge a slightly higher interest rate than they do on HELOCs to make up for it. However, the HELOC rate could always go up later, depending on market conditions. Consider asking your lender how often the rate will change (monthly, quarterly, semi-annually) and if there is a ceiling rate.

Selecting the best loan product for you

Home equity loans and credit lines are popular with consumers for a reason: They offer competitive rates compared to other forms of credit. Plus, you may be able to write off the interest you pay, as long as your loan meets IRS requirements. If you're a homeowner with a substantial amount of equity in your property, both of these products are worth considering when you truly need the money.

Home equity loans may provide the better choice if you have a one-time need—say, a home repair or debt consolidation. Because they generally come with a fixed interest rate, they're also popular with borrowers who crave predictability. Unlike variable-rate loans, you don't have to worry about your financing costs going up down the road.

A home equity line of credit could be a good fit for individuals and couples who want a flexible source of cash they can tap without having to reapply for a loan or pay additional closing costs. Just beware, though: That flexibility can also tempt you to overspend on nonessential goods and services.

And as with home equity loans, borrowing against your home can put you at risk of losing your home if you can't pay the lender back in a timely manner. As with other forms of borrowing, you may want to seek out alternatives like finding new income sources or holding off on discretionary expenses, if possible.

Alternatives to home equity loans

Keep in mind that you may wish to consider other forms of credit if you need a large amount of cash or plan to make a major purchase. If you're planning to do home repairs, for example, roofing and window companies may offer competitive financing for consumers with strong credit. Some even offer 0% introductory rates, although you'll want to check what rate kicks in if you have a remaining balance after that period ends. And if you need to purchase a new or used car, you may want to compare traditional auto loans through the dealership or your bank, where you won't have to deal with hefty closing costs.

To obtain cash or consolidate debt, cash-out refinances are another option. Instead of getting a second mortgage against your home, you replace your original mortgage with a larger loan and receive the difference in cash. Say you own a home worth $500,000 and owe $300,000 on your original mortgage. If you get a cash-out refinance with a $350,000 loan, $300,000 of it pays off that earlier mortgage and the remaining $50,000 helps you pay off credit card bills or pay other debts.

Like home equity loans and lines of credit, you'll need a significant amount of equity in your home to do a cash-out refinance. And it probably doesn't make sense if your existing loan has a lower rate than you'd get on your new mortgage. But when rates go down, cash-outs suddenly become more attractive.

Shopping for a loan

With interest rates climbing and homeowners sitting on a record amount of equity, demand for second mortgages has been strong. Consequently, borrowers may have to look broadly to find a lender.

As with any large loan, you may want to shop around to make sure you're getting the right deal. You can explore traditional banks, as well as credit unions and nonbank mortgage lenders. Generally, it's a good idea to compare at least three to four offers to make sure you're getting the best deal. But you may want to bunch those applications within a 30-day window to avoid dragging down your credit score.

To do an apples-to-apples comparison, get all the details of the loan in writing. For a home equity loan, the lender should provide you with a Loan Estimate, a three-page document that lays out the amount borrowed, interest rate and all closing costs. Some of these expenses may be negotiable, so try to get the best deal you can.

Always look at the overall cost of the loan, not just the interest rate. You may find that a loan or HELOC with a slightly higher rate actually costs less if the closing costs are lower. The annual percentage rate, or APR, factors these upfront expenses into the interest rate, providing a more accurate picture of what you're paying to borrow those funds.

The bottom line

Borrowing a substantial amount of money can have a big impact on your financial health. You can always connect with a financial advisor beforehand to decide whether an equity loan or line of credit is truly right for you.

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Thrivent Credit Union is an Equal Housing Lender. NMLS ID 1012971

Deposit and lending services are offered by Thrivent Credit Union, the marketing name for Thrivent Federal Credit Union, a member-owned not-for-profit financial cooperative that is federally insured by the National Credit Union Administration and doing business in accordance with the Federal Fair Lending Laws. Insurance, securities, investment advisory and trust and investment management accounts and services offered by Thrivent, the marketing name for Thrivent Financial for Lutherans, or its affiliates are not deposits or obligations of Thrivent Federal Credit Union, are not guaranteed by Thrivent Federal Credit Union or any bank, are not insured by the NCUA, FDIC or any other federal government agency, and involve investment risk, including possible loss of the principal amount invested. Must qualify for membership.
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