Breaking Down the Key Differences between a HELOC and Home Equity Loan
Many homeowners often find themselves in a position where they need to borrow against the equity in their home but are unsure of what option they should choose. Is it better to get a home equity loan or a Home Equity Line of Credit (HELOC)?
To help you determine which might work best for you, we’ve broken down the key differences between the two options along with the pros and cons of each.
Home Equity Loan
What Is A Home Equity Loan?
A home equity loan is essentially a mortgage that allows you to borrow funds against the equity you have in your home.
How much equity you have can be determined by taking the value of your home and subtracting your existing mortgage.
For example, let’s say you own a home that is worth $250,000, and you owe $150,000 dollars on your mortgage. This means you have $100,000 in home equity that you can borrow against.
However, keep in mind that with a home equity loan, you can only borrow against up to 80% of this amount.
Home equity loans also come with a fixed interest rate and repayment term. This means you will have a fixed monthly payment to make that will not change throughout the life of the loan.
Pros and Cons of a Home Equity Loan
The main pros of a home equity loan include:
- Fixed monthly payments, loan terms, and interest rates make a home equity loan extremely predictable and unchanging
- The money can be used for anything
- Interest rates tend to be much lower than other debts such as unsecured loans and credit cards
On the other hand, there are also some cons of a home equity loan. Cons include:
- Your home is used for collateral, so you risk foreclosure if you are unable to make payments
- Some home equity loans come with added fees
- You must determine how much money you want to borrow upfront
Home Equity Line of Credit (HELOC)
What Is A Home Equity Line of Credit?
Similar to a home equity loan, a HELOC also allows you to borrow funds against the equity in your home.
But rather than receiving the funds in one lump sum, you will get a revolving line of credit that you can borrow funds from whenever you need the money.
Therefore, you only end up repaying the funds that you actually borrow.
So how much can you borrow?
With HELOCs, you can usually only borrow up to 80% of your home’s value.
And as for interest, they typically come with a variable interest rate that is based on the financial institutions prime rate – however some lenders may allow you to convert these to fixed rates.
Because payments are based on how much money you borrow, and interest rates are variable, monthly payments can vary and possibly fluctuate over time.
Pros and Cons of a HELOC
Pros of HELOCs include:
- You only borrow funds as you need them, rather than one large lump sum
- HELOC rates often remain low
- They often come with either no fees or low fees
Cons of a HELOC include:
- Your home is used as collateral, putting you at risk of foreclosure if payments are not made
- Payments can fluctuate depending on your interest rate and how much you borrow
- The interest rate is usually higher than one of a mortgage or home equity loan
How does a HELOC and Home Equity Loan Differ From One Another?
It’s clear that these two borrowing options have a lot of similarities, but how exactly are they different from one another?
There are a few key areas where HELOCs and home equity loans differ, such as:
A HELOC allows you to borrow as much – or as little – as you need up to your credit limit at any time within the borrowing period.
But with a home equity loan, the amount that you borrow is given to you in one lump sum after the loan is approved.
For HELOCs, interest rates are variable, and are usually more than just the prime (for example Prime + 0.5% = 3.95% + 0.5% = 4.45%).
A home equity loan can also have a variable interest rate, but is most often a prime (for example prime – 1% = 3.95% – 1% = $2.95%)
The primary difference between the two is the fact a HELOC can be paid as an interest only payment, whereas a Home Equity Loan or mortgage is always principal + interest, therefore the mandatory payments are higher.
Keep in mind that if you only pay the interest on the HELOC, then you are not paying down your debt. The HELOC balance will be indefinite if you only pay interest payments
With HELOCs, repayment options are typically flexible, and your payments often vary.
Home equity loans, on the other hand, have fixed rates and monthly payments.
Closing costs are usually quite minimal with a HELOC. In fact, many HELOCs come with absolutely no closing costs at all.
A home equity loan/mortgage should have the same costs of registration as the HELOC.
Which One Should You Choose?
Since both options are fairly similar in the sense that each lets you borrow against the equity in your home, trying to decide between a home equity loan or a HELOC can be a difficult task.
But in the end, it all comes down to your own preference and particular borrowing needs.
Consider why you are seeking out a loan or HELOC along with how much money you need and how you plan to use it.
Both options are often used for:
- Debt Consolidation
- Emergency funds
- Home Renovations
- Post-secondary education
Regardless of how you plan to use the funds, if you require the full amount of your loan all at once, then a home equity loan could be a good option for you.
You would also go with a home equity loan if you want to pay the least amount of interest over time, and/or want a structured principal and interest payment.
But if you are hoping to have the smallest payment possible and want the flexibility of borrowing at your own pace, then a HELOC may be a better solution.
When contemplating either a HELOC or home equity loan, work with a mortgage broker to find out more about what each option entails and which is most suitable for your particular needs.
A broker will be able to thoroughly explain the benefits of both options, and help you find a home equity loan or line of credit that is right for you.
Chris Allard’s experience in the field means he can get you offers with over 50 financial institutions lending in Ottawa. Every lender has many mortgage products they offer, which means Chris and his team will make sure a mortgage caters to your needs while also ensuring you get a competitive rate. Chris Allard is a proud mortgage broker of Smart Debt Mortgages, independently owned and operated. Smart Debt broker #12236.