Three Key Differences Between HELOCs and Home Equity Loans Loaner

Lately, homeowners have been turning to their equity for their liquidity needs.

After all, most already have a very low fixed mortgage rate and don’t want to disrupt it in any way.

If they were to go the cash out refinance route, they would lose their old low rate and end up with a much higher rate.

To avoid this, they can take out a second mortgage and keep the existing first mortgage intact.

The question is: do you opt for a HELOC or a home equity loan?

How HELOCs and Home Equity Loans Are Similar

If you’re like many people trying to understand the difference between a home equity line of credit (HELOC) and a home equity loan, let me help you.

There are basically three main differences between the two, although both options share many of the same qualities. Let’s discuss them first before getting into their differences.

First, they often act as a second mortgage. And they both allow you to tap into the equity in your home.

You can get money from either and you can do it without disrupting your first mortgage.

Nothing changes with your first mortgage when you take out a second mortgage like a HELOC or home equity loan.

And that’s a good thing if you’re getting one of those 3%, 30-year fixed mortgage rates that were available for much of the last decade.

So either choice will allow you to continue to take advantage of this low rate, unlike a cash-out refinance, which would pay off your old loan and create a new one.

If that makes sense, let’s move on to these three main reasons why they’re different.

HELOCs are open-ended lines of credit, home equity loans are balloon payments

Now let’s talk about these key differences. One of the biggest differences is that a HELOC is an open-ended line of credit, while a home equity loan is an open-ended lump sum loan.

Let’s talk about the home equity loan first, because it’s easier to understand. You request X amount of dollars and receive that amount at closing.

For example, if you apply for a $50,000 home equity loan, you get $50,000 at closing and repay it monthly.

This is a one-off transaction that allows you to borrow a specific amount, just like a loan for the purchase of a home.

Except it’s underwritten by existing homeowners who leverage their equity and then use the proceeds for whatever they want, like another investment, college tuition, other expensive debt, etc.

Vice versa, the HELOC works more like a credit card in that you apply for a credit limit and then borrow as little or as much as you want.

Using the same $50,000 example, you would get a credit limit of $50,000 using your home equity as collateral.

You can then borrow from it as you wish, or perhaps just keep it open as an emergency line if cash needs arise in the future.

Additionally, you can borrow multiple times during the draw period, which can often last up to 10 years.

So you can borrow the entire line ($50,000), repay part of it, then borrow again during this window.

With the home equity loan, you can only borrow once. Simply put, the HELOC offers more flexibility, similar to a credit card. While the home equity loan works like a standard loan.

Advice: Pay attention to the loan origination fee (if applicable), which may apply to the initial draw or the total loan/line amount when comparing options.

HELOCs are variable rate, home equity loans are fixed rate

The next big difference is that HELOCs are variable rate loans, while home equity loans are fixed rate loans.

The home equity loan may have a fixed rate of, say, 9% or 10% and that’s where it will stay for the life of the loan.

It will not be subject to any price adjustment, so you will benefit from certainty of payment each month.

Plus, because the home equity loan is a balloon loan, you’ll know exactly what the payment amount is each month. This will not change.

Meanwhile, the HELOC is tied to the prime rate, which is determined by the Federal Reserve. Every time the Fed lowers or raises rates, the prime rate will change by the same amount.

For example, the Fed recently cut rates by a half point and then another quarter point.

This lowered the prime rate by 0.75%, so those who already have HELOCs saw their interest rate drop by that much.

In other words, a HELOC holder with a rate of 8% now benefits from a rate of 7.25%. A significant advantage if rates fall. But they can also go up.

Because of this uncertainty, HELOC interest rates are generally lower than home equity loan rates.

Advice: The Fed is expected to continue cutting rates through 2025, so it’s likely HELOC rates will fall further as well.

HELOCs come with an interest-only period

The final difference between these two loan products is that HELOCs offer an interest-only period.

During the draw period of a HELOC (when you are able to withdraw money from the line of credit), the minimum payment required is usually interest only.

You therefore do not need to repay the capital (amount you borrowed). You only have to pay the interest part. This is often an option of up to 10 years.

Therefore, you can benefit from a lower monthly payment during the draw periodprobably less than the comparable home equity loan, which requires full repayment up front.

The advantage is that your monthly payments are smaller. The downside is that you could pay higher interest if you don’t repay the loan until later.

And once the draw period ends on the HELOC, your payments will increase as the loan amortizes over the remainder of the term, perhaps 20 years or less.

This means the choice between the two could come down to a question of cash flow, with the HELOC offering greater payment flexibility. And the borrowing options initially.

The home equity loan provides peace of mind with a fixed rate, but also requires you to borrow the full amount at closing, which you may not actually need. And you won’t be able to use it in the future.

To summarize, HELOCs are variable-rate, open-ended lines of credit with multiple payment options.

While home equity loans are fixed lump sum loans that require fully amortized payments, including both principal and interest.

Take the time to compare the two to ensure you find the right product for your unique situation.

A final issue is that some lenders now offer fixed-rate HELOCs, like the Figure Home Equity Line, so the products can be a little harder to compare.

Continue reading: Cash Out, HELOC or Home Equity Loan: Which is the Best Option Right Now and Why?