HELOC vs. Home Equity Loan: Similarities and Differences

A Home Equity Line of Credit (HELOC) and a Home Equity Loan are two financial products that allow homeowners to borrow money against the equity they have built up in their home, but they are not exactly the same. They have many similarities, but also key differences.

HELOC (Home Equity Line of Credit)

A HELOC is a revolving line of credit that allows you to borrow money against the equity in your home. It works somewhat like a credit card, where you can borrow up to a certain limit and pay interest only on the amount you borrow. You can draw funds from your HELOC as needed and repay them over time. HELOCs typically have variable interest rates.

Home Equity Loan

A home equity loan, frequently referred to as a second mortgage, provides a lump sum of money upfront that you repay in fixed monthly installments over a set period. The interest rates for home equity loans are usually fixed, meaning they remain constant throughout the loan term.

Key Differences

• HELOC: It's a revolving line of credit, similar to a credit card. This means you can borrow up to a certain limit, repay it, and borrow again.
• Home Equity Loan: This is a lump-sum loan. You receive the entire loan amount upfront and then pay it back in fixed monthly payments over a set term.
• HELOC: Generally has a variable interest rate that can change over time.
• Home Equity Loan: Usually offers a fixed interest rate, making your monthly payments consistent.
• HELOC: Often has two phases – a draw period where you can access the funds and only pay interest, followed by a repayment period where you pay back the principal with interest.
• Home Equity Loan: You start paying both principal and interest from the beginning, with a set end date for when the loan will be fully repaid.
• HELOC: More flexible; you can use as much or as little of the line of credit as you need.
• Home Equity Loan: Best for one-time expenses where you know the exact amount you need.

Pros and Cons

HELOC Pros:

• Flexibility in borrowing and repaying.
• Only pay interest on the amount you actually borrow.
• Can be a good option for ongoing projects or expenses.

HELOC Cons:

• Variable interest rates can lead to higher costs if rates rise.
• Can be risky if the value of your home drops.
• Requires discipline to manage a revolving line of credit responsibly.

Home Equity Loan Pros:

• Fixed interest rates provide predictable monthly payments.
• Good for large, one-time expenses.
• Simpler for those who prefer a regular repayment schedule.

Home Equity Loan Cons:

• Less flexibility compared to a HELOC.
• Interest starts accruing on the entire loan amount right away.
• Can put your home at risk if you default on the loan.

Both options have their advantages and disadvantages, and the best choice depends on your individual financial situation, the amount of money you need, and how you plan to use the funds.

Advice on HELOCs and Home Equity Loans

Money expert Clark Howard has a hard and fast rule about when you should get home equity loans and HELOCs:

Do not use your home equity to pay off credit card debt. Credit card debt is unsecured, meaning it doesn’t put your assets at immediate risk if you fail to pay. In contrast, mortgage debt, including that from a second mortgage like a HELOC or home equity loan, is secured by your home. Failure to meet these payments can lead to losing your home.

Additionally, if there’s a significant drop in housing values, having a second mortgage could result in owing more on your home than it’s worth, a situation known as being “upside down” on your mortgage. This will be exacerbated if you have used the home equity debt for something other than home improvements.

If you use a HELOC, you should have a plan to repay it within 3 years. Anything longer than that exposes you to the risk of unexpected increases in interest rates.

Differences in Impact on Your Credit

Both a Home Equity Line of Credit (HELOC) and a Home Equity Loan can have an impact on your credit score, but they can affect it in slightly different ways due to their distinct structures:

• HELOC: Since a HELOC is a revolving line of credit, it's similar to a credit card in how it impacts your credit utilization ratio, which is a significant factor in your credit score. High utilization (i.e., using a large portion of your credit line) can negatively impact your credit score.
• Home Equity Loan: This is a type of installment loan. While taking out the loan increases your total debt, it doesn't affect your credit utilization ratio the same way a revolving credit does. However, a high level of overall debt can still negatively impact your credit score.
• Both HELOC and Home Equity Loans will result in a hard inquiry on your credit report when you apply, which can temporarily lower your credit score.
• Opening a new account (whether a HELOC or a Home Equity Loan) can also lower your average account age, potentially impacting your credit score.
• For both types of loans, timely payments will positively impact your credit score, while late payments or defaults can significantly damage it. Payment history is the most crucial factor in your credit score.
• Both loans contribute to your overall debt, which lenders look at when evaluating new credit applications. A high debt-to-income ratio can make it more challenging to obtain additional credit.
• While not directly related to your credit score, it's important to note that both HELOCs and Home Equity Loans are secured by your home. Failure to repay can lead to foreclosure, which would have a severe negative impact on your credit history.
• Having a mix of credit types (revolving credit and installment loans) can positively impact your credit score. So, if you don't already have an installment loan, a Home Equity Loan could improve your credit mix, and similarly, a HELOC could be beneficial if you only have installment loans.

Both HELOCs and Home Equity Loans can impact your credit score through inquiries, the amount of debt you carry, your payment history, and your credit mix. However, the HELOC’s impact on your credit utilization ratio is a unique aspect that differs from the effect of a Home Equity Loan.

Final Thoughts

If you decide to get a HELOC or Home Equity Loan, make sure you use our HELOC calculator or our Home Equity Loan calculator to estimate your monthly payments and your total cost of borrowing.

The post HELOC vs. Home Equity Loan: Similarities and Differences appeared first on Clark Howard.