Home Equity Loan vs. HELOC: What’s the Difference?

What Is Home Equity?

Both home equity loans and HELOCs use the equity in your house as collateral—that is, the portion of your home's appraised value that belongs to you outright. To determine your equity if you're currently paying a mortgage on the house, you must find out from your lender how much you still owe on your mortgage, and deduct that amount from the appraised value of the home.

For example, let's say you took out a $300,000 mortgage on your house and you've paid down $100,000 so still owe $200,000 on the loan principal. In the meantime, property values in your neighborhood have climbed, and the appraised market value of your well-maintained house has increased to $350,000. Your equity in the house is its appraised value minus the unpaid mortgage amount: $350,000 - $200,000 = $150,000.

You typically cannot get a home equity loan or HELOC for the full amount of your equity in the house; lenders typically limit loan amounts to 75% to 80% of your total equity. If they're concerned you won't be able to repay the debt, they may insist on a smaller percentage of equity, or decline to issue you any loan at all, no matter how much equity you have. Continuing with the above example, with $150,000 in equity, your borrowing will be limited to between $112,500 and $120,000.

What Is a Home Equity Loan?

A home equity loan is a lump sum of money you borrow against the equity in your home. Home equity loans are often called second mortgages. Like your primary mortgage, a home equity loan is secured by your home—meaning the lender can seize the property if you fail to repay the loan as agreed.

The current annual percentage rate (APR) on home equity loans start at about 3% and range to 12% or higher. As with interest rates on most loans, the rate you qualify for will depend on factors including your credit score (with higher scores getting the lowest interest rates), income, and how much you spend on other debts each month.

What Is a Home Equity Line of Credit (HELOC)?

A home equity line of credit gives you access to a pool of money—the credit line, or borrowing limit—that you can draw from as needed by writing checks or making charges or cash withdrawals with a dedicated card. You don't pay interest or have to make payments until you use your credit, and then, as with a credit card, you can make payments of any amount (as long as you meet a monthly minimum) to pay down the balance as quickly or as gradually as you are able. The longer you take to pay the balance, the more you'll pay in interest charges.

Unlike a credit card account, which typically stays open as long as you continue using it and making required payments, a HELOC has a fixed lifespan that gets divided into two phases:

• The draw period: You can use the account to borrow and repay money freely. This period typically lasts 10 years, at which point the loan moves into the repayment period.
• The repayment period: You can no longer borrow against the credit line during this time, and must repay the outstanding balance. The repayment period typically lasts 20 years.

The lengths of your draw period and repayment period will be specified in the HELOC loan agreement.

Interest rates on HELOCs are often variable, tied to published market rates and currently range from a low of 2.5% to as much as 21%. The rate you're offered will depend on your credit scores, income, and the lender's policies.

Differences and Similarities Between a Home Equity Loan and a HELOC

The main difference between a home equity line of credit and a HELOC concerns the way you receive and repay what you borrow. Depending on the way you intend to use the borrowed funds, one or the other may be considerably more affordable in terms of interest charges.

With a home equity loan, you receive the full amount of your loan once the loan is approved, and you must repay it over a set number of fixed monthly payments. Repayment periods typically range from five to 10 years, but 20- and even 30-year terms are possible. The amount of interest you'll pay over the life of the loan is essentially known from the start; you may be able to save some interest by repaying the loan early, but some lenders charge penalties for paying loans off ahead of schedule.

With a HELOC, you can potentially save on interest charges if you keep your withdrawals relatively small and pay down your balances between expenditures.

You may be able to deduct interest payments on home equity lines of credit and HELOCs when you file your federal income taxes, just as you do primary mortgage interest charges. Through at least 2026, you may only deduct interest on home equity loans or HELOCs if the loan proceeds are used to make home improvements. Your total annual deduction on interest from all mortgage, home equity and HELOC loans cannot exceed $750,000.

Alternative Types of Loans

Home equity loans and HELOCs can be welcome sources of ready cash for qualifying homeowners, but they carry significant risks: If you are unable to keep up with your payments on a home equity loan or HELOC, the lender has the right to foreclose and take possession of your home.

Alternatives to home equity loans and HELOCs that don't risk jeopardizing your home include the following:

• Personal loan: A personal loan is a form of unsecured credit, which means it doesn't require you to put up property as collateral against the debt. Loan amounts can range from $1,000 to $10,000, and interest rates vary widely, according to credit score and income level. You may be able to qualify with a fair credit score, but a credit score in the good range or better will give you access to a wider range of choices.
• Personal line of credit: Banks and credit unions allow borrowers with good credit to open personal lines of credit—revolving credit accounts that don't require collateral or that use the contents of a certificate of deposit (CD) as collateral. Like HELOCs, these credit lines allow withdrawals and payments in variable amounts, and only charge interest on outstanding balances. Personal lines of credit have finite draw and repayment periods, which are typically shorter than those for HELOCs—as little as three to five years each.
• Peer-to-peer loans: These can be had through online financial institutions that match investors wishing to issue loans with borrowers seeking loans. Known as peer-to-peer or P2P lenders, these sites don't always check credit scores, but they do typically require evidence of income and other assets. Peer-to-peer platforms can be a good resource for smaller loans (typically $5,000 or less). Repayment periods on P2P loans are typically fairly short, five years or less.

A home equity loan or HELOC can be a tremendous resource for homeowners seeking cash. While there are no limitations on how you use them, using loan proceeds for home improvements can also offer some tax benefits. Which option is better for you may depend on how you plan to use the funds. A home equity loan may make sense for a single major renovation, which will cost a large sum all at once. On the other hand, a HELOC may make more sense if you're considering a series of smaller maintenance projects, and can save interest costs by paying back each expenditure before beginning a new one.

Make Sure Your Credit Is Ready

No matter how you decide to cover your costs, whether it's with a home equity loan or HELOC, your credit will be an important factor in how much it'll ultimately cost. If possible, check your credit three to six months before submitting your application. That'll give you time to address any issues you might find and potentially improve your scores before you borrow. You can check your credit report for all three credit bureaus for free through AnnualCreditReport.com. Your free credit report and scores are also available through Experian as well.