Wondering whether you should go for a home equity loan or a home equity line of credit (HELOC)? We’ve got you covered! While both home equity loans and lines of credit allow homeowners to access their property’s value for cash, they function differently and are suitable for varying circumstances. With interest rates trending higher in 2024, the popularity of the line of credit and home equity loan programs have soared.
Home Equity Loan vs Line of Credit: How Do They Work?
A home equity loan provides a lump sum of money at a fixed rate, that you can repay over a set period.
It’s ideal if you have a specific project or expense in mind.
On the other hand, a HELOC is similar to a credit card.
It offers flexible access to funds up to a certain limit, with a variable interest rate.
This makes it suitable for ongoing expenses or emergencies.
To understand home equity loans vs lines of credit better, you need to know more about these popular second mortgages in detail.
Home Equity Loan
Equity is the difference between the market value of your home and the outstanding balance on your mortgage. So, what is a home equity loan?
A home equity loan, often referred to as a second mortgage, is a type of loan that allows homeowners to borrow against the equity they have built up in their property. Let’s explore the line of credit vs home equity loan narrative so you can make an informed decision when borrowing against your home.
Home equity loans provide a lump sum of money upfront, which you can repay over a fixed period, usually ranging from 5 to 30 years. The equity loan is amortized with a fixed interest rate. This loan is secured by the home, meaning that your lender can foreclose on the property in case of failure to repay the amount.
Given this security, home equity loans generally come with a lower interest rate compared to unsecured loans like personal loans or credit cards.
Since your house is a collateral for the loan, the amount you can borrow depends largely on the current market value of your home, as well as on your mortgage, credit score, and income.
Given that the borrowed amount is fixed, people generally use home equity loans for renovations or small projects around the house, where the cost is predictable.
Home Equity Line of Credit
Let’s move forward and discuss home equity lines of credit. When considering the the comparison of home equity line of credit vs home equity loan you need to step back and get some perspective.
Lines of credit work similar to credit cards, providing borrowers with access to a predetermined amount of funds that they can draw from as needed.
Once approved for a line of credit, you can withdraw funds up to the credit limit whenever you want cash. Note that you are only charged interest on the amount borrowed, instead of the entire credit limit.
As you repay the borrowed funds, the available credit replenishes, allowing for future use. The credit line is amortized with a variable interest rate and the borrower is expected to make at least interest only payments on the portion of the line they use.
The repayment terms vary depending on the lender and the type of line of credit. HELOCs are secured by your home’s equity and typically have variable interest rates. You can borrow against your home’s equity up to a predetermined limit, and the repayment period often spans several years. If you are using your home as collateral, you need to strongly consider both sides of the home equity line of credit vs loan debate.
Personal lines of credit on the other hand are unsecured and usually have higher a interest rate than HELOCs. You can access funds as needed, up to a certain limit, without collateral. Repayment terms generally vary but may include monthly payments or minimum monthly interest payments.
How to Qualify for a Home Equity Loan and Line of Credit?
For approval of any type of loan, you need to meet a set of financial criteria that lenders use to assess your ability to repay the borrowed funds.
While we’re on home equity loans vs lines of credit, it is essential to know that the qualification requirements for both are generally similar.
Here’s what you need to know:
Good Credit Score
Your credit score is a critical factor in qualifying for either a home equity loan or a HELOC. A good credit score indicates a history of responsible credit management, which reassures lenders of your reliability.
Typically, a minimum credit score of 620 is required, but scores of 700 or higher are preferred to secure better interest rates and terms. Higher credit scores can also increase your chances of approval, especially for HELOCs where a variable interest rate might be involved.
It is also important to note that even if you get approved for a loan with a low credit score, you are likely to end up with unfavorable terms such as a limited amount, comparatively higher interest rate, or shorter repayment period.
Debt to Income Ratio (DTI)
The DTI ratio is calculated by dividing your total monthly debt payments by your gross monthly income. Lower DTI ratios indicate that you have sufficient income to cover your debts, including the new loan or credit line payments.
When you apply for a home equity loan or HELOC, your lender will look for a DTI of 43% or lower. However, in some cases, higher ratios may be acceptable provided that you have a strong credit history or significant equity. Read about the current HELOC requirements that were recently updated.
If you have a high DTI, here are some steps you can take to improve the ratio:
- Pay Down Existing Debt: Focus on paying off high-interest debts, such as credit card balances or personal loans. Reducing your overall debt load can lower your DTI ratio.
- Increase Your Income: Even a temporary increase in income can make a significant difference in your DTI ratio. Consider taking on a part-time job or freelance work to boost your gross monthly income.
- Refinance Existing Loans: If you have high-interest loans, refinancing them at a lower interest rate can reduce your monthly payments, thereby lowering your DTI.
- Consolidate Debt: Debt consolidation can streamline multiple high-interest debts into a single loan with a lower interest rate and monthly payment, improving your DTI ratio.
Equity Requirements
Equity in your home is a fundamental requirement for both home equity loans and HELOCs. Most lenders require that you have at least 15-20% equity in your home.
Equity is calculated by subtracting your outstanding mortgage balance from your home’s current market value. For instance, if your home is worth $400,000 and you owe $250,000 on your mortgage, you have $150,000 in equity, which is about 37.5%.
Income and Employment Verification
A stable income and a steady employment history are understandably required to qualify for a loan. After applying, you will have to present documents like recent pay stubs, tax returns, and bank statements that substantiate your financial stability.
Property Appraisal
An appraisal of your property will be necessary to determine its current market value accurately.
This appraisal ensures a reliable estimate of your home’s worth and the amount of equity available. Both home equity loans and HELOCs use this appraisal to establish the loan-to-value ratio (LTV), which helps determine the amount you can borrow.
Keeping the LTV ratio at or below 80% is important because it lowers the lender’s risk, can qualify you for better loan terms, and helps you avoid private mortgage insurance (PMI).
Closing Costs and Fees
When applying for a loan, always make sure to factor in closing costs and fees in the process. This can be in the form of appraisal fees, origination fees, as well as title search fees.
Benefits of HELOC Line of Credit vs Home Equity Loan
Home equity loans and lines of credit offer distinct advantages. Let’s review them:
Fixed vs Variable Interest Rates
The equity loans typically come with a fixed interest rate, which provides predictability in monthly payments throughout the loan term.
On the other hand, lines of credit often feature a variable interest rate, and you need to be prepared for potential rate fluctuations over time.
Predictable Payments
With home equity loans, you receive a lump sum upfront and can make consistent monthly payments. This makes it easier to budget.
In contrast, lines of credit offer flexibility in payments, allowing you to make minimum payments or pay off the balance in full as needed.
Usage and Purpose
Home equity instalment loans are well-suited for specific, planned expenses. On the other hand, lines of credit offer flexibility for various financial needs, making them perfect for multiple expenses over time.
Interest Expense
Lines of credit charge interest only on the amount that is used, which offers potential cost savings for people who utilize a smaller portion of their credit line. In contrast, equity loans collect interest on the entire loan amount, regardless of how much is withdrawn.
Tax Deductibility
Both home equity loans and lines of credit may offer tax deductions on interest payments, subject to certain limitations. Under current tax laws, interest paid on loans secured by a primary or secondary residence may be deductible, up to a certain limit.
Home Equity Loan vs Line of Credit: Which is Better?
When you apply for a loan, choosing between a home equity loan and a line of credit depends on your individual financial needs and preferences.
If you have a one-time expense like a renovation project coming up, I’d suggest you go for a home equity loan as it is released as a lump sum payment, and has fixed interest rates.
Alternatively, for unpredictable expenses, like emergency home repairs or short-term cash flow gaps, it is advisable to go for the credit line as it gives you on-demand access to funds.
Read more about what the CFPB says about the equity lines and loans. The Consumer Finance Protection Bureau was created to further educate consumers looking to borrow money in the United States.
Frequently Asked Questions for Home Equity Loans and Lines of Credit
What is the difference between a home equity loan and a line of credit?
Home equity loans and lines of credit both allow you to borrow against the equity in your property. However, they differ in terms of disbursement, repayment structure, and flexibility in accessing funds.
A home equity loan provides a lump sum upfront, with a fixed interest rate and fixed monthly payments over a set term. The home equity loan is considered an installment loan.
In contrast, a line of credit (HELOC) gives you access to a revolving credit line, which allows you to withdraw funds as needed. The interest rates on lines of credit loans are also variable and fluctuate with time. The HELOC has a draw period and a repayment period. During the draw period, borrowers can use funds over and over and only pay interest monthly.
Once the draw period ends, the repayment period begins. Borrowers can longer access the HELOC funds during the repayment period. The HELOC month payments increase during the repayment period because the debt and interest are being paid back over 10 or 15 years in most cases. Many people will choose to refinance into a home equity loan at this point so they can lock into a fixed rate and fixed monthly payment.
What are the interest rates for home equity loans and credit lines?
Since equity loans and HELOCs are considered second mortgages, the interest rates are slightly higher than traditional mortgage rates. In most cases, borrowers can expect 2nd mortgage rates to be 1.5 to 3% higher than 1st mortgage rates depending upon the loan to value, credit score, loan amount and debt t income ratio for the borrower.
What are the difference between a home equity line of credit vs home loan
Most home loans are amortized between 15 and 30-years. The most common home loan is the fixed 30-year mortgage, but you can choose adjustable or fixed interest rates with home loan programs. A HELOC provides ongoing access to funds. Unlike a conventional loan, a HELOC is a revolving credit line, allowing you to borrow multiple times. In this way, it’s similar to a credit card, but with a HELOC, like a traditional mortgage, your home is used as collateral.
The main reason to choose a conventional home loan is the lower interest rate compared to a secured credit line. In most cases, home mortgages offer lower interest rates because they are secured in 1st position on title. The minimizes the risk for mortgage lenders. Some private money lenders will include a prepayment penalty. Whereas HELOCs do not typically have penalty for early payoff..
Pros and cons of the personal loan vs home equity line of credit
Personal loans are ideal for one-time, fixed expenses, while home equity lines of credit are better suited for homeowners that need funding for projects or purchases that require flexibility. Both options typically offer lower average rates than credit cards for borrowers with good credit. Home equity draw periods and repayment terms vary based on the amount borrowed and the length of the term.
What is the benefits and risks with the construction loan vs home equity line of credit?
When financing your construction project or home renovation, homeowners have several options. Two popular choices are construction loans and home equity loans. Both can provide the necessary funds for your project, but it’s important to understand the differences between them before deciding. This section will explore the key factors to consider when choosing between a construction loan and a home equity line of credit, offering insights from various perspectives to help you make an informed choice.
What is the difference between a bridge loan vs home equity line of credit
A bridge loan is a short-term solution meant to “bridge” the gap between buying a new home and selling your current one. In contrast, a HELOC provides a flexible line of credit over a longer period, suitable for various financial needs. While HELOCs offer flexibility in how funds can be used, bridge loans are specifically for covering the costs and expenses related to purchasing a new home.
What are the disadvantages of a home equity line of credit?
While a home equity credit line works great when you have multiple expenses, they do have some drawbacks.
Firstly, the interest rates are variable, which can lead to unpredictable monthly payments. Additionally, failure to repay the borrowed amount could result in the loss of home equity and foreclosure.
On top of that, you will also have to deal with hefty fees during application and for maintaining the line of credit.
Is HELOC cheaper than a home equity loan?
HELOCs may initially offer lower interest rates than home equity loans. However, the interest rates fluctuate based on market conditions and your financial situation, due to which line of credit may not always be cheaper than a home equity loan. In most cases the closing costs are the same for equity loans and HELOCs. Occasionally, a lender will advertise a no closing cost HELOC. It is important to always read the fine print and these no closing cost loans usually require a 750 credit score and below 80% loan to value (LTV).
What are the debt to income ratio requirements for home equity loans and HELOCs?
Debt-to-income (DTI) requirements for home equity loans and home equity lines of credit can differ depending on the lender, but most traditional lenders prefer a DTI below 35–36%. However, some specialized home equity lenders may accept a debt to income ratio as high as 45%.
Can I get a line of credit or home equity loan with low credit scores?
The quick answer is yes, but there are more challenges in qualifying for a bad credit HELOC or getting approved for a low credit home equity loan in today’s lending environment. If you have a credit score between 500 and 620 you will need more equity to qualify. Look at it this way, the lower your credit score, the more you equity you will need to qualify for a line of credit or home equity loan. There are hard money and non QM lenders advertising bad credit second mortgage programs this year, so it is possible to get a HELOC or equity loan with below average credit.
How much money can I borrow on a home equity loan?
How much money you can borrow on a home equity loan depends on factors such as your home’s value, outstanding mortgage balance, as well as the lender’s criteria. Generally, lenders allow borrowers to access up to 80 to 90% of their home’s equity, minus any existing mortgage balance. Of course the less equity you have the higher the credit score will need to be to get qualified.
Key Points on the Home Equity Loan vs Home Equity Line of Credit Choice
Both a home equity line of credit and a home equity loan allow you to borrow money against the appraised value of your home, providing you with cash when you need it. Here’s an explanation of the terms and the differences between the line of credit vs home equity loan to help you determine if they are right for you.
If you’ve built up equity in your home—meaning its value exceeds the balance on your mortgage—you can use part of that equity to meet financial needs such as home improvement projects, large expenses, education costs, or unexpected expenses.
The equity line of credit and home equity loan are two ways to access your home’s equity, but they function differently. Understanding how each one works can help you decide which option might be better suited to your needs. BD Nationwide can help you shop and compare the best home equity lenders online and there is no application fee or obligation.
