Consider all your options before you take out that second mortgage.
HELOC vs. Home Equity Loan: Which One Is Best For You?
Updated on Sep. 30, 2024
If you’re a homeowner, you likely already understand how important your house’s value is. A home is a financial investment, and buying low and selling high can yield significant windfalls. However, many homeowners don’t want to wait until they sell their house to reap the benefits of this financial investment, or otherwise feel they need to tap into their home equity as a way to make ends meet in the present.
To do so, homeowners can take out a second mortgage using a home equity loan or open a HELOC—home equity line of credit. But how do you know which method is right for you? Here, we’ll walk you through what exactly home equity loans and HELOCs are, and give each method’s pros and cons as well as advice on how to choose between them. Armed with this information, you will be able to make the wisest financial choice when borrowing against your home equity.
What Is a Home Equity Loan?
When someone thinks of a second mortgage, a home equity loan is usually what they picture. Home equity loans allow homeowners to draw out a lump sum of money at a fixed interest rate. To repay it, they make a stable monthly payment for a set period of time, in addition to their usual mortgage payments. However, if property values in your area decline, taking out all the equity on your home at once can ultimately work against you.
Pros
- Fixed interest rate
- Stable, predictable monthly payments
- Access to a large lump sum of money at once
Cons
- Interest is paid as an entire lump sum, not just the amount used
- This may result in an ultimately smaller payout if property value declines
What Is a HELOC?
Think of a HELOC as a credit card. Homeowners will have a certain amount of credit available to them and then can withdraw against it as they need. They will only pay interest on the amount of equity they use.
Typically, HELOCs start with lower interest rates than home equity loans; however, they change with the market, making the monthly payments less predictable. Still, many HELOC lenders will allow homeowners to convert a portion of what they owe to a fixed interest rate. The balance of the line of credit will stay at a variable rate.
Pros
- Interest compounds based on the amount your draw, not on the total equity available
- May be able to make interest-only payments during the draw period
Cons
- Monthly payments can be unpredictable as interest rates change
- Easy to overspend, which will increase your principal and payments during the repayment period
How to Choose
Before you choose between a home equity loan and a HELOC, think carefully about what you intend to spend the money on. Home equity loans are typically best suited to one-time withdrawals, while home equity loans may make more sense as a continual source of credit. Then, speak to a financial professional about the interest rates, fees and tax payments described by various lenders.
Consider speaking to a real estate expert about the housing market in your area as well. Finally, reflect honestly on your own spending habits. How do you manage your credit card? Are you likely to be tempted by unnecessary short-term purchases? The answers to these questions will help you determine if a using a HELOC could undermine your financial health.
No matter which form of borrowing you choose, remember that at the end of the day, you are still using loaned money and placing your house up for collateral. With that in mind, do not spend more than you absolutely need, or else you will run the risk of substantially driving up your repayment amount. And, as with all major financial decisions, remember that what’s right for one person may not be the best choice for you.
