Home equity line of credit (HELOC) vs home equity loan: How do they work?

Home equity lines of credit (HELOCs) and home equity loans are two similar finance tools — methods of borrowing money against the ownership stake you have in your home.  Both typically allow you to tap up to 80 or 85 percent — even 90  percent — of your home’s value, minus your outstanding mortgage balance.

Let’s look more closely at how HELOCs and home equity loans work, and how to determine which would work best for you.

Understanding home equity loans and HELOCs

Though similar, these two forms of financing have significant differences.

Home equity loan: What is it?

A home equity loan is a secured installment loan that allows you to borrow a set amount against your equity at a fixed interest rate and repayment term.

HELOC: What is it?

A home equity line of credit (HELOC) is also secured. But it’s a revolving debt that offers an amount of funds (a replenishable balance, similar to a credit card limit) tied to the level of equity in your home. You pay a variable interest rate on whatever you withdraw.

Key differences between HELOCs and home equity loans

Similarities between HELOCs and home equity loans

HELOCs and home equity loans act as second mortgages, using your property as collateral for the debt. So, defaulting on the monthly loan payments means the lender could foreclose your home. And, as with your primary mortgage, you can expect closing costs whether you choose a home equity loan or HELOC.

Both funding options allow you to use the funds however you see fit. Many borrowers use them to pay for major home repairs or renovations, like finishing a basement, remodeling a kitchen or updating a bathroom. Others use them to pay off high-interest credit card debt or other bills.

Pros and cons of a home equity loan

Advantages

• You’ll have a fixed interest rate and predictable monthly payment.
• You’ll get all of the loan proceeds at closing and can spend them however you see fit.
• Loans often don’t charge origination fees, which’ll save you money at closing.
• The interest paid on the loan might be tax-deductible if the funds are used to upgrade your home.

Disadvantages

• You’ll need to know exactly how much you want to borrow. If you don’t, you might end up with more or less than you need, which means you’ll either be stuck repaying the portion you didn’t use plus interest, or need to borrow more money.
• You’ll need a sufficient level of home equity to qualify — usually 15 percent to 20 percent.
• You could lose your home if you fall behind on the loan payments.
• If property values decline, your combined first mortgage and home equity loan might put you “upside down,” meaning you owe more than your home is worth.

Pros and cons of a HELOC

Advantages

• You have the option to pay only interest during the draw period; this might mean your monthly payments are more manageable compared to the fixed payments on a home equity loan.
• You don’t have to use (and repay) all of the funds you’ve been approved for. Interest is charged solely on the amount you’ve borrowed.
• Some HELOCs come with a conversion option that allows you to set a fixed rate on some or all of your balance. This might help shield your budget from fluctuating-rate increases.

Disadvantages

• HELOCs have variable rates. In a rising-interest rate environment, that means you’ll pay more monthly. This unpredictability could wreak havoc on your budget.
• Many HELOCs come with an annual fee, and some come with prepayment penalties, aka cancellation or early termination fees, if you pay your line off sooner than the repayment schedule dictates. Home equity lenders often charge a fee for variable-to-fixed-rate conversions, too.
• You could lose your home to foreclosure if you don’t repay the line of credit.
• If property values decline abruptly or a recession occurs, the lender could reduce your credit line, freeze it or even demand immediate repayment in full.

Why are HELOCs and home equity loans popular now?

Before we get into more details, a brief look at the home equity lending scene today.

HELOCs and HE Loans are having a moment. True, originations of home equity loans were down 3 percent year over year (from Q3 2022 to Q3 2023) according to TransUnion’s most recent  “Home Equity Trends Report,” their HELOC cousins declined 28 percent in the same period. But this slowdown is deceiving. Compared to earlier years, HELOC originations are actually on par with pre-pandemic norms, while home equity originations are actually above the figures recorded between 2008 and 2021.

What’s the appeal? The RIIR (the rise in interest rates) throughout 2022 and 2023 — particularly mortgage rates, which have doubled since their mid-pandemic lows — have decimated the appeal of cash-out refinancing, once the go-to way to tap a homeownership stake. Hence, the interest in home equity loans and HELOCs. While these products’ rates have risen in recent years too — HELOCs in particular ended 2023 averaging above 10 percent — they’ve stabilized and even dropped in the new year.  Looking to the future, HELOC rates are projected to decline even further, potentially averaging about 8.45 percent by the end of 2024. 

Of course, all this home equity borrowing is made possible by the record-setting rise in home prices since the start of the pandemic, which has increased the value of homeowners’ equity stakes. The average mortgage holder now has $299,000 in equity, up from $274,000 at the end of 2022, according to ICE Mortgage Technology, a real estate data analysis firm.

Loan specifications

Home equity loans generally come with long repayment terms, sometimes up to 30 years. The exact terms and the interest rate depend on your credit score, payment history, income and the loan amount. Your home acts as collateral, and the lender can foreclose on it if you default on the loan payments.

With a HELOC, you’ll only be able to use the funds during the draw period — typically the first 10 years. When the draw period ends, you’ll have a certain amount of time to repay what you borrowed plus any interest, usually up to 20 years.

Requirements for HELOCs and home equity loans

Each lender has its own eligibility criteria for home equity loans and HELOCs. However, here are some general guidelines to keep in mind:

• Credit score: A credit score of 620 could be enough with some lenders, but aim for 700 or higher to have the best approval odds (and get the best interest rates).
• Income: Your income should be consistent and verifiable.
• Debt-to-income (ratio): You’ll need an acceptable DTI to qualify for funding.
• Equity: Lenders generally allow you to borrow from 80 and 90 percent of your home equity, which is the difference between your home’s value and what you owe.
• Appraisal: The lender will require an appraisal to determine how much your home is worth or its fair market value. (Note: The appraisal is arranged by the lender, and the fee is included in the closing costs).

How to obtain a home equity loan

Home equity loans are available through banks, credit unions and online lenders. Some offer online prequalification tools that let you view loan offers with estimated monthly payments and terms without impacting your credit score.

If you decide to formally apply, you can typically start the process online and upload the requested documentation to get a lending decision. You can also visit a branch if you’re doing business with a traditional bank or credit union. Either way, formally applying for a home equity loan will result in a hard pull that impacts your credit score.

Note: Home equity loans come with a three-day cancellation rule, aka the right of rescission. It allows you to back out of the contract without penalty within three business days.

Obtaining a home equity loan or line of credit

How to obtain a HELOC

The process for obtaining a home equity loan and HELOC are similar, as are the qualifications. However, HELOCs may be harder to get in some cases, with more stringent criteria. For example, peer-to-peer lender Prosper sets a 660 credit score minimum for HELOCS, vs. 640 for home equity loans.

The three-day right of rescission rule also applies for HELOCs. That said, the funds disbursement method varies between the two, as mentioned above.

Am I able to get a home equity loan or HELOC with bad credit?

Even if you have less than ideal credit, it’s still possible to obtain a home equity loan or HELOC. It’s not likely that you’ll get the most competitive interest rate, but if you have reliable income and a relationship with a lender, you could qualify for a loan.

There are also lenders that will approve home equity loans and HELOCs for borrowers who have FICO scores as low as 620, provided that you meet other requirements related to debt levels, equity and income.

In addition to a credit score of at least 620, in order to earn approval, you’ll likely need about 15 percent to 20 percent equity in your home and a maximum debt-to-income (DTI) ratio of 43 percent, or up to 50 percent depending on the lender. Lenders also like to see an on-time mortgage payment history.

Choosing between HELOC and home equity loan

How to decide between a home equity loan and a HELOC? Ask yourself these questions.

Which type of loan is better for your needs?

A home equity loan could be a good fit if you know what you’ll use the funds for, when you’ll need them and exactly how much you’ll need. However, a HELOC could work better if you don’t know exactly the total expense you’ll incur, and/or you’ll need to keep a ready source of funds on hand. Or, if your costs will extend over a long period of time (like paying a home contractor in installments, or college tuition for four years).

Are you a set-it-and-forget-it type?

Do you prefer predictability in your obligations? A home equity loan is ideal if you like a fixed interest rate and monthly payment that won’t ever change. And you’re not an interest-rate watcher.

A HELOC on the other hand, could be ideal if you hate the idea of being locked into a higher-than-market interest rate, or paying interest on money you haven’t spent. You don’t mind — and have the means to cover — fluctuating payments.

Are you disciplined?

HELOCs can be a slippery slope to more debt than you can handle if you only repay the interest during the draw period and none of the principal. Taking this approach can cause sticker shock when the HELOC repayment phase begins and you have a substantial debt left to repay. Unless you expect to come into a significant sum of money or windfall in the future, it’s a good idea to pay both principal and interest during the draw period on a HELOC, and not give in to the temptation of minimal, interest-only payments.

If that’s not you, a HE Loan might be a better choice, as it imposes a repayment schedule on you, similar to your mortgage. It helps to prevent the debt from becoming unmanageable.

Bottom line on home equity loans and HELOCs

Home equity loans and HELOCs both allow you to borrow money against your home equity, but they’re not the same. Consider the purpose of the funds, how much you need and whether or not you’ll want to borrow more in the future. Once you decide, get your credit in good shape and shop around to secure the best rate.