Lately, homeowners have been turning to their equity for their cash needs.
After all, most already have a super low fixed mortgage rate and don’t want to disturb it in any way.
If they were to go the cash out refinance route, they’d lose their old low rate and wind up with a much higher one.
To avoid this, they can take out a second mortgage instead and keep the existing first mortgage intact.
Question is: Do you go with a HELOC or a home equity loan?
How HELOCs and Home Equity Loans Are Similar
If you’re like a lot of folks trying to understand the difference between a home equity line of credit (HELOC) and home equity loan, allow me to help.
There are basically three main differences between the two, despite both options sharing a lot of the same qualities. Let’s discuss those first before we get into their differences.
First off, they both often act as second mortgages. And they both allow you to tap into your home equity.
You can get cash from either and you can do so without disturbing your first mortgage.
Nothing changes with your first mortgage when you take out a second mortgage like a HELOC or home equity loan.
And that’s a good thing if you’ve got one of those 3% 30-year fixed mortgage rates that were available for much of the past decade.
So either one you choose will allow you to continue enjoying that low rate, unlike a cash out refinance, which would pay off your old loan and create a new one.
If that makes sense, let’s move on to those three main reasons why they’re different.
HELOCs Are Open-Ended Lines of Credit, Home Equity Loans Are Lump Sum Payouts
Now about those key differences. One of the biggest differences is that a HELOC is an open-ended line of credit, whereas a home equity loan is closed-end, lump sum loan.
Let’s discuss the home equity loan first because it’s easier to understand. You apply for X amount of dollars and receive that amount at closing.
For example, if you apply for a $50,000 home equity loan, you get $50,000 at closing and pay it back monthly.
It’s a one-time deal that allows you to borrow a specific amount, just like a home purchase loan.
Except it’s taken out by existing homeowners who tap their equity and then use the proceeds for whatever they wish, such as another investment, college tuition, other high-cost debt, etc.
Conversely, the HELOC operates more like a credit card in that you apply for a credit limit and then borrow as little or as much of it as you wish.
Using the same $50,000 example, you’d get a $50,000 credit limit using your home equity as collateral.
You could then borrow from it as you wish, or perhaps just keep it open as an emergency line if cash needs come up in the future.
Also, you can borrow from it multiple times during the draw period, which is often as long as 10 years.
So you could borrow the whole line ($50k), pay some of it back, then borrow again during this window.
With the home equity loan, you only get to borrow one time. Simply put, the HELOC provides more flexibility, similar to a credit card. While the home equity loan operates like a standard loan.
Tip: Pay attention to the loan origination fee (if applicable), which may apply to the initial draw or full loan/line amount when comparing options.
HELOCs Are Variable-Rate, Home Equity Loans Are Fixed-Rate
The next big difference is that HELOCs are variable rate loans, while home equity loans are fixed-rate loans.
The home equity loan might have a fixed rate of say 9% or 10% and that’s where it will remain for the entire loan term.
It won’t be subject to any rate adjustments, so you’ll enjoy payment certainty each and every month.
In addition, because the home equity loan is a lump sum loan, you’ll know exactly what the payment is each month. It won’t change.
Meanwhile, the HELOC is tied to the prime rate, which is driven by the Federal Reserve. Whenever the Fed lowers or raises rates, the prime rate will move by the same amount.
For example, the Fed recently cut rates by one-half point and then another quarter-point.
This pushed prime down by 0.75%, so those who already have HELOCs have seen their interest rate come down by that amount.
In other words, a HELOC holder with an 8% rate now has a rate of 7.25%. Nice perk if rates happen to be falling. But they can also go up.
Due to this uncertainty, HELOC interest rates are generally lower than home equity loan rates.
Tip: The Fed is expected to keep cutting rates into 2025, so chances are HELOC rates will also fall further.
HELOCs Come with an Interest-Only Period
The final difference between these two loan products is HELOCs offer an interest-only period.
During the draw period of a HELOC (when you’re able to pull out money from the credit line), the minimum payment required is typically interest only.
So you don’t need to repay the principal (amount you borrowed). You only have to pay the interest portion. Often, this is an option for up to 10 years.
As a result, you can enjoy a lower monthly payment during the draw period, likely less than the comparable home equity loan, which requires full repayment from the get-go.
The upside is you have smaller monthly payments. The downside is you might pay more in interest if you don’t pay down the loan until later.
And once the draw period ends on the HELOC, your payments will jump up as the loan amortizes over the remainder of the term, perhaps 20 years or less.
This means the choice between the two might come down to cash flow, with the HELOC providing more payment flexibility. And borrowing options initially.
The home equity loan provides peace of mind in a fixed rate, but also requires you to borrow the full amount at closing, which you might not actually need. And you can’t draw on it again in the future.
To summarize, HELOCs are variable rate, open-ended lines of credit with multiple payment options.
While home equity loans are closed-end, lump sum loans that require fully-amortized payments including both principal and interest.
Take the time to compare the two to ensure you wind up with the right product for your unique situation.
One last wrinkle is some lenders now offer fixed-rate HELOCs, such as the Figure Home Equity Line, so the products can be a little more difficult to compare.
Read on: Cash Out vs. HELOC vs. Home Equity Loan: Which Is the Best Option Right Now and Why?
Before creating this site, I worked as an account executive for a wholesale mortgage lender in Los Angeles. My hands-on experience in the early 2000s inspired me to begin writing about mortgages 18 years ago to help prospective (and existing) home buyers better navigate the home loan process. Follow me on Twitter for hot takes.