Home Equity Loan vs. HELOC: A Homeowner's Guide

A home equity loan and a home equity line of credit (HELOC) are both ways to borrow against the equity in your home, but they work very differently. A home equity loan gives you a lump sum of money at a fixed interest rate that you repay in equal monthly installments. A HELOC gives you a revolving line of credit you can draw from as needed, typically at a variable interest rate, similar to how a credit card works but secured by your home.

Both options use your home as collateral, which means the interest rates are generally lower than personal loans or credit cards, but also that your home is at risk if you fail to repay.

The right choice depends on how your project is structured and how certain you are of the total cost.

A home equity loan is generally better when you have a defined scope with a known total cost. You receive the full amount upfront, your rate is fixed, and your monthly payment is predictable from day one. This works well for homeowners who have completed planning and have a final contract price in hand.

A HELOC is generally better when your project will be phased over time or when the final cost is not fully known yet. Because you draw only what you need when you need it, you minimize the interest you pay on funds sitting idle. The tradeoff is a variable rate that can increase as the project progresses.

• Home Equity Loan: You apply, get approved for a lump sum, receive the funds at closing, and begin repaying immediately in fixed monthly installments. The rate does not change for the life of the loan.

• HELOC: You apply and get approved for a credit limit. During the draw period (typically 5 to 10 years) you can borrow up to the limit, repay, and borrow again. Interest is charged only on what you have drawn. After the draw period ends, you enter repayment and can no longer draw funds.

Only when the funds are used to buy, build, or substantially improve the home securing the loan. Using HELOC funds for a remodel on the same property generally qualifies, but consult a tax professional for your specific situation. Do not assume deductibility without verification.

Most lenders require you to maintain at least 15 to 20 percent equity in your home after the loan. If you owe $400,000 on a home worth $600,000, you have $200,000 in equity and could potentially borrow up to $80,000 to $110,000 depending on the lender's combined loan-to-value limit.

• Is the interest rate fixed or variable, and what is the maximum rate cap on a HELOC?

• What are the closing costs and fees for each option?

• Is there a prepayment penalty on the home equity loan?

• How long is the draw period and what happens to my payment at the end of it?

• How quickly can funds be available after approval?

See also: Remodeling Financing Options, Remodeling ROI, Contingency Fund, Kitchen Remodel Cost Breakdown, Bathroom Remodel Budget