HELOC vs. home equity loan: Which is right for you?

Tapping into home equity is a powerful tool that most homeowners can use to fund a better life, whether that’s sending children to college, crossing off much-needed repairs from to-do lists, or purchasing a second home.  

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Home equity lines of credit (HELOCs) and home equity loans are two of the most common ways to achieve these ends without replacing your entire mortgage, but they both work very differently and are more appropriate for distinct funding needs. In addition, it’s worth considering whether other equity-based borrowing options are a better fit. 

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We’ll help you decide on whether a HELOC vs home equity loan — or even something else entirely — is best for you in this comprehensive guide.

What is a home equity line of credit (HELOC)?

A home equity line of credit is a type of revolving debt that allows you to borrow money on an as-needed basis up to a credit limit specified by your lender. It’s similar to how a credit card works, although it’s secured by your home. That’s why lenders generally charge less interest on a HELOC vs a credit card; if you default on the debt, your lender can foreclose on your home to secure repayment. 

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Many homeowners prefer HELOCs due to their on-demand access to flexible funds, which can be especially useful in certain situations:

• Starting a new business
• A reserve funding option for emergencies
• Paying for college tuition for a loved one each semester
• DIY home upgrade projects done over a long period of time

How does a HELOC work?

Although HELOCs function similarly to credit cards, it’s important to realize that you can only use them for a limited period of time. Most HELOCs are split up into two different phases: a 5 – 10-year draw phase, when you can borrow money, and a 10 – 20-year repayment phase when you’ll finish paying back the debt. 

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Typically, during the draw phase, you’ll only be required to make interest-only payments, which is a lot less than if you’d taken out a loan. You can, however, choose to pay down your balance and restore access to your full line of credit. This can also help you save money on interest charges. Once the repayment period begins, you’ll make full interest and principal payments on your debt, and you won’t be able to borrow funds any longer. 

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Most lenders charge a variable interest rate with a HELOC. This can cause your monthly payment to constantly shift, which can also be caused by changes in the amount you owe and whether you’re in the draw or repayment phases. Many homeowners find this to be the biggest drawback since ever-shifting payments can be hard to plan for in your budget.  

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Some lenders offer “hybrid” HELOCs that allow you to convert a portion of your balance into a home equity loan with fixed rates, which can be beneficial if rates are low and you’re looking to stabilize your payments. 

What are the requirements for a HELOC or home equity loan?

The requirements to get approved for a HELOC vs. home equity loan are generally similar. Each lender has its own requirements and may differ, but in general, here’s what you can expect: 

• Credit score: 620 or higher
• Home equity: 20% or higher
• Monthly income: Stable and consistent
• Debt-to-income ratio: 43% or less

You can use this calculator to see if you may qualify for a HELOC.

Pros and cons of a HELOC

There are many similarities in some of the pros and cons of HELOCs vs. home equity loans. You run the risk of losing your home through foreclosure if you default on either option, for example, and both are typically limited to homeowners with good credit and income. However, you can write the interest off on your taxes if you use the funds to upgrade your home regardless of whether you choose a home equity loan vs. HELOC, and both options can help you build credit over the life of the loan with on-time payments. 

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Aside from these general considerations, here are some of the pros and cons of HELOCs in particular:

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Pros

• Flexible access to funds: Borrow as much as you want up to your credit limit during the HELOC draw phase. 
• Save on interest if you’re not borrowing: Many homeowners prefer to keep a $0 balance on their HELOC, only using it as needed for emergencies. 
• Interest-only payments during draw period: Dollar-for-dollar, HELOC minimum payments are cheaper during the draw phase because you’re not required to start repaying the debt. 

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Cons

• Easier to overspend: Having an open line of credit available can tempt some people into spending more money on unnecessary items, driving them further into debt. 
• May charge annual fees: Some HELOCs come with annual fees, regardless of whether you borrow money or not. 
• Fluctuating monthly payments: Variable interest rates, changing balances, and switching from interest-only to full payments can make your budget rather chaotic. 
• Higher interest rates than home equity loans: The average bank charged 8.49% on a HELOC in December 2023, versus 7.14% for a five-year home equity loan. 
• May require minimum draws or outstanding balances: Some lenders require you to borrow a certain amount when you first open the HELOC or on a more regular basis in order to ensure you’re charged interest.

What is a home equity loan?

A home equity loan is a much simpler way to borrow money against the equity in your home. You’ll receive funds in a single lump sum with a home equity loan vs. a home equity line of credit. Since they’re not as flexible, they’re less popular with homeowners: only 10% of second mortgages are composed of home equity loans, as opposed to 90% for HELOCs. 

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Even so, there are good reasons to choose a home equity loan over a HELOC:

• You don’t want the temptation to keep spending money
• You’re looking to consolidate higher-interest debt into one loan
• You’re making a single large purchase, such as buying solar panels or hiring contractors

How does a home equity loan work?

A home equity loan is disbursed in one lump sum payment into your checking account once you’ve gone through the underwriting process and are approved. You’ll begin making payments immediately, and since home equity loans generally charge a fixed interest rate, your payment will stay the same until your debt is completely paid off. A typical term length for a home equity loan is five to 20 years. 

Pros and cons of a home equity loan

In addition to the pros and cons of home equity funding — in general — that we’ve already brought up, there are a few points specific to home equity loans that you should consider. 

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Pros

• Less risk of borrowing too much: A one-and-done deal reduces the danger of overborrowing, as can occur when you have a blank check in the form of a HELOC. 
• Predictable, fixed-rate payments: Home equity loan payments start right away and stay constant over time until the loan is paid off, making it easier to fit in your budget. 
• Lower interest rates than HELOCs: Smaller interest rates mean you’ll be charged less over the life of the loan.

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Cons

• Higher upfront payments than HELOCs: You’ll start repaying your outstanding balance right away, unlike HELOCs which initially allow for interest-only payments. 
• Must reapply every time you need funds: If you need to borrow money in the future, you can’t tap back into a line of credit like with a HELOC — you’ll need to go through the whole loan process all over again. 
• Can’t benefit from lower rates as with HELOCs: You won’t be able to take advantage of falling interest rates since your loan is locked in at a set rate when you sign the dotted line. However, the opposite is also true — you could lock in a permanently lower rate. 

HELOC vs. home equity loan: Which is right for you?

In most cases, your funding needs will dictate whether a home equity line of credit vs. a home equity loan is better. If you have an ongoing need to borrow funds — or even just want the extra peace of mind that you have it as an option — then choose a HELOC. If you’re looking to make a large one-time-only purchase, generally a home equity loan is best. 

Final thoughts

Home equity loans and lines of credit can be an excellent way to borrow funds at a lower cost than unsecured debt such as personal loans and credit cards. However, they’re not your only options if you’re looking to tap into your home equity when you need to borrow money. 

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Home equity investments (also known as home equity agreements or home equity sharing agreements) offer a lump sum of funds up-front, similar to a home equity loan. However, home equity investments are not a debt, and repayment is due as a percentage of your home’s growth in value at the end of a 30-year term or when you sell your home (whichever comes first). 

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This offers ultimate flexibility since you aren’t required to make payments in the interim. By learning more about how home equity investments work, you can make a more informed decision about the best financing options for your family. You can also check your home’s eligibility and see how much you can unlock.