Comparing Home Equity Loans vs HELOC: Which is Better For You?

By Chika

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Last Updated: November 24, 2021

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Your home has intrinsic value, but provided you are living in it, you may not be able to exploit the value to meet your pressing needs.

Two ways which you can access the value of your home is through Home-equity loan and Home Equity Lines of Credit (HELOCs). 

Though both types of loan allow you to borrow against your home equity they are structurally different. An understanding of how each one works can help you decide which is suitable for you.

 

What is a Home Equity Loan?

A home equity loan is one which allows you to borrow against your home equity.

It is secured by your home (i.e. your home acts as collateral), and comes with a fixed interest rate and repayment term. The interest rate depends on factors such as amount, credit score, payment history and income level. 

A home equity loan is akin to taking another mortgage. You borrow a certain percentage of the equity you own in your home, repaying the lender at a fixed rate over a stipulated period (usually 10 to 15 years).

 

What is a HELOC?

A Home Equity Line of Credit operates like a credit card loan, except that your home is used as collateral.

The credit limit which HELOC offers is tied to the amount of equity you have built up in your home. A HELOC has a specified borrowing period (usually 10 years) during which you can tap into your line of credit to withdraw money.

Interest rates on HELOC vary and are tied to the benchmark interest rates set by the Federal Reserve. As such, you need an understanding of what the prevailing interest rates are before applying for a loan.

 

Home-equity loan vs HELOC

 

Home Equity Loan

HELOC

Interest rate

Fixed

Variable. You only pay interest on the amount you borrow

Disbursement

Lump sum

Revolving; smaller amounts

Repayment

Fixed monthly payments

Interest-only payments during draw periods, followed by fixed monthly payments

Credit score points

You can get lower interest rates due to your credit score

Credit score does not affect interest rates which are determined by benchmark interest plus margin designated by the lender.

 

When is a Home Equity Loan Right For You?

A home equity loan usually comes in a lump sum with fixed interest rate over a specific period.

This type of loan is best suited for capital projects or increasing one’s net worth. The predetermined repayment period gives the borrower some sort of stability in that he knows how much he would pay each month, which helps him plan better.

The lump sum amount (which is usually up to 80% of the equity in the home) implies that this cash should be used to generate more cash or used to reduce your debt profile.

As such, you should not spend your home equity loan on frivolities or necessities because you have not only reduced the equity of your home by borrowing, but also the added interest rate, increasing your debt burden.

The best ways to utilize your home equity loan are:

  • investing in equities
  • starting a business
  • home improvement (to increase the value of your home)
  • paying existing debt (to improve your credit score)

 A major shortcoming with home equity loans is that accessing your home equity in your home in one fell swoop can work against you if not properly utilized.

 

When is a HELOC right for you?

HELOC operates like a credit card loan.

It is best suited for short-term needs like:

  • paying for tuition
  • medical bills
  • carrying out repairs
  • emergency payments

Since the interest rates vary and could increase with time, plus you only pay interest on the amount you borrow, it is advisable that you do not take out large sums, but only tap into this line of credit as a last resort. 

The major shortcoming against HELOC is that interest rates can rise, which would increase the total amount paid. Secondly, since it is revolving much like a credit card, there is the possibility that the borrower would overspend, or spend on frivolities.

 

Final Word

Borrowing against your home equity can free up cash which can be allocated to other purposes.

However, if these loans are not managed or utilized properly, you could lose your home. This thought should be at the back of the mind of anybody that wants to borrow against his home.

As such, before you borrow, have a detailed plan on how you intend to repay.

If you want to start a business or invest in equity, it is expedient you carry out feasibility studies. If you want to pay medical bills or settle an emergency using HELOC, then you should take cognizance of the benchmark interest rates of the loan.

Photo by Brendan Church on Unsplash

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