One of the primary benefits of owning a home instead of renting is being able to build home equity. Your house is an asset, and as you pay off your mortgage, you are building up more and more value added to your net worth. And although you can simply sit on that value, you can also put it into action by borrowing against it to fund present-day expenses like home improvements or sending a kid to college.
Of course, deciding to make use of the value you’ve built up in your home is just the first step. Once you’ve decided it’s worth borrowing against your home equity, you’ll need to decide between a basic home equity loan and a home equity line of credit (HELOC), sometimes referred to as an “open end” home equity loan.
Read on to understand how the two types of loans are similar and different before making a final choice.
Understanding Home Equity Loan vs. Line of Credit
Simply put, a home equity loan is a straightforward loan secured with the value of your house that you’ve built up over time by paying down your mortgage — or by buying your house outright, should you be so lucky. You’ll receive the entire loan amount in a lump sum once you’re approved, you’ll have a set repayment period — usually between five and 15 years — and most often you’ll have a fixed interest rate on the loan.
A HELOC is similar in that you’re securing a loan against the value of your home, but it’s also a revolving line of credit. This means that the entire amount is available for you to borrow, but you can draw on that line of credit as much or as little as you need or want to during the “draw period.”
Perhaps the best comparison would be to a personal loan and a credit card, which are similar to a home equity loan and HELOC, respectively. A personal loan is a lump sum your lender offers up at a fixed rate, but a credit card will come with a preapproved amount of money the issuer is prepared to lend you that you can deploy at your convenience.
Find Out: 10 Best Home Improvement Loans
How Are Home Equity Loans and HELOCs Different?
The primary difference between a HELOC and a home equity loan is the way that you access and repay the funds. A HELOC is meant to be a more flexible loan, so there will be a “draw period,” usually of five to 10 years, during which you can make use of the available funds and during which your payments will be very small, usually just covering the interest.
After the end of the draw period, there’s then a repayment period, which can vary in length but is usually at least a decade or more, during which time you’ll begin to repay the money that you drew down from your HELOC.
Another important difference between the two loans is in the interest rates. A home equity loan will typically have a fixed interest rate, but HELOCs will usually rely on a variable interest rate that can shift up or down with changes in the prevailing interest rates. So you might pay a higher or lower rate depending on where in the draw period you make use of your line of credit.
Which Loan Is Right for You?
There are pros and cons for each type of loan, so making the right decision has everything to do with your specific circumstances. If you have a major expense — along with a clear sense of exactly what it will cost you — you’re likely better served by taking the fixed interest rate and the lump sum with a home equity loan. You’ll have greater certainty about the repayment terms and total interest costs over the course of the loan, allowing you to plan and budget more precisely. So, if you’re planning on purchasing a vacation home or rental property, a home equity loan might be the better plan.
If you’re in any situation in which you know you’ll need access to cash but you can’t be certain about how exactly much — or even over how long a period — a HELOC could be better for you. By taking advantage of the greater flexibility provided by a HELOC, you can only borrow what you need and avoid paying interest on what you don’t. If you have a child going to college, you can borrow money for tuition or lodging over time, avoiding paying interest on borrowed money until you actually need it.
Other examples might be less certain. Home improvement loans are often a smart way to make use of your home equity, as you should be improving the value of your home in the process. So depending on your circumstances, a home equity line of credit versus a home equity loan isn’t such a clear choice.
If you feel certain that you’ll be able to rely on initial estimates for the cost of the project, then a home equity loan will give you fixed, predictable interest costs and could be better for you. If the project has a good chance of incurring cost overruns, however, then you might want to rely on a HELOC instead, allowing you to go back and borrow more to cover unexpected expenses without needing to pay the fees associated with originating a new loan. Your level of certainty will be a key factor in making your decision.
Up Next: How to Get a Loan
More on Home Equity