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[Prefer to listen? You can find a podcast version of this article here: E262: Home Equity Loan vs. HELOC – What’s the Difference and Which One Is Right for You?]

Tapping into your home’s equity can be a helpful way to access funds for major expenses. However, choosing between a home equity loan and a home equity line of credit (HELOC) can be confusing.

Both options let you borrow against the value of your home, but they function in very different ways, and understanding the pros and cons of each is key to making the right decision.

What Is Home Equity?

Home equity is the difference between what your home is worth and what you still owe on your mortgage. For example, if your home is valued at $500,000 and you owe $300,000 on your mortgage, you have $200,000 in equity.

Lenders typically allow you to borrow up to 85% of your home’s value, minus what you owe on your mortgage. That’s the equity you may be able to tap through either a home equity loan or a HELOC.

Home Equity Loan: Fixed and Predictable

A home equity loan is essentially a second mortgage. You receive a lump sum upfront and pay it back over time with a fixed interest rate.

Pros of a Home Equity Loan

• Predictable Payments: The interest rate and monthly payment are fixed, making budgeting easier.
• Lump Sum: Ideal if you need a large amount of money all at once.
• Lower Interest Rates: Typically lower than credit cards or personal loans because the loan is secured by your home.

Cons of a Home Equity Loan

• Less Flexibility: You borrow a fixed amount. If you need more later, you’ll need to apply for another loan.
• Higher Monthly Payments (Potentially): Since you’re paying interest and principal on a fixed timeline, the payments may be higher than minimum payments on a HELOC.
• Risk to Your Home: Defaulting on the loan could lead to foreclosure.

When to Use a Home Equity Loan

A home equity loan is a good option when you know exactly how much money you need and plan to use it all at once. Common scenarios include:

• Debt Consolidation: If you’re carrying high-interest credit card debt, using a home equity loan to pay it off can reduce your interest rate and monthly payments.
• Major Home Renovation: Think roof replacement or a kitchen remodel, where you have a specific, one-time budget.

Home Equity Line of Credit (HELOC): Flexible and Accessible

A HELOC functions more like a credit card. You’re approved for a certain credit limit and can borrow, repay, and borrow again during the draw period—typically 10 years.

What Is the Draw Period?

The draw period is the initial phase of a HELOC, usually lasting 5 to 10 years, during which you can access the available credit as needed. You can borrow, repay, and then borrow again—similar to how a credit card works. During this time, your payments are often interest-only, which keeps monthly payments lower.

Once the draw period ends, the HELOC enters the repayment period, which can last 10 to 20 years, depending on the terms. At this point, you can no longer borrow from the line of credit, and you’ll begin repaying both principal and interest. This transition often results in a higher monthly payment.

Pros of a HELOC

• Flexibility: You only borrow what you need, when you need it.
• Interest-Only Payments (During Draw Period): This can make early payments lower.
• Revolving Access to Funds: Useful for ongoing expenses or projects with unpredictable costs.

Cons of a HELOC

• Variable Interest Rate: Your rate may rise, which can increase your payments unexpectedly.
• Temptation to Overspend: Easy access to funds can lead to borrowing more than necessary.
• Balloon Payments: Once the draw period ends, you enter a repayment phase that may include larger payments or a balloon payment.

When to Use a HELOC

A HELOC makes sense when your expenses are spread out over time or when you’re not sure exactly how much you’ll need. Examples include:

• Ongoing Home Improvements: Like updating multiple bathrooms or finishing a basement over several months or years.
• Emergency Fund Backup: If your emergency savings are low, a HELOC can provide a safety net for unexpected expenses.
• Education Costs: Tuition and related expenses that come in recurring payments.

Comparing Costs and Terms

Both home equity loans and HELOCs typically have closing costs similar to a primary mortgage, usually 2% to 5% of the loan amount. And because your home serves as collateral, interest rates are generally lower than unsecured options.

However, interest on home equity borrowing is only tax-deductible if the funds are used to “buy, build, or substantially improve” the home. Debt consolidation or education expenses won’t qualify for the deduction.

Which One Is Right for You?

It comes down to how and when you plan to use the money.

If you want predictability and a one-time payout, a home equity loan may be the better fit.

If you prefer flexibility and plan to access funds over time, a HELOC likely makes more sense.

A Quick Word of Caution

Both options carry risk. You’re borrowing against your home, and if you fall behind on payments, foreclosure is a real possibility.

Before you move forward, make sure your budget can support the additional monthly obligation and that the funds will be used to improve your overall financial situation, not just to postpone dealing with deeper financial issues.

Using home equity wisely can be a powerful financial tool. Whether it’s renovating your space, consolidating debt, or funding a major life event, understanding your options helps you make smarter choices.