A HELOC is a home equity line of credit. A HELOAN is a home equity loan.
When you live in a home, your equity is locked up. The only way to reach it to use this value is through a home equity lending product. That means obtaining a line of credit or a loan.
Both a HELOC and a HELOAN are classified as a second mortgage. The difference is that instead of using the funds to purchase your primary property, you’re using the equity in the home as collateral. You would then make payments on this lending product that are above and beyond the usual monthly mortgage.
How Do I Calculate Home Equity?
The reason why equity is locked up in your home while you’re living there or own the property is because it is the difference between what you owe and the value of the home.
Let’s say that you purchase a home for $150,000 today. In 5 years, you’ll have made 60 mortgage payments and the value of the property increases to $175,000. The home equity that you have in this property is the $25,000, then whatever the principal amount of the mortgage decreased by because of your payments.
NerdWallet uses this example. If you have a $300,000 home and owe $150,000, then dividing what you owe into the value creates a loan-to-value ratio of 50%. If you were allowed a 30% home equity loan with an 80% LTV ratio, then you might qualify for a HELOC or HELOAN of $90,000.
Why HELOCs Might Be Better for You
With a HELOC, you gain the ability to secure a line of credit against the full amount of the equity built up in your home. Because it is a line of credit, however, this creates something that similar to a credit card in the way the financial product operates. When you need it, then you can access the funds.
If not, then you can leave the HELOC alone and maintain the value of the equity you’ve built.
Because there is more risk with this type of flexibility, you’ll find that the costs of a HELOC are a little higher than a HELOAN over the life of the product. Many HELOCs begin with a low interest rate, often lower than a fixed home equity loan.
HELOCs are usually adjustable-rate, however, which means your monthly rate could rise quickly and unexpectedly. It is based on a specific benchmark, so it is important to know what will trigger changes in your interest rates and payment.
The opposite is also true. The interest rate on a HELOC could go down, which would mean you’d have a lower payment than what you started at if the markets move in your favor.
There is one downside with a HELOC vs a HELOAN that everyone should consider. If you are not financially disciplined, it is possible to overspend on this line of credit. That would tap out your equity, you’d be stuck with large, probably adjustable monthly payments, and you’d still be stuck with your monthly mortgage.
Why HELOANs Might Be Better for You
One of the primary benefits of taking a HELOAN is that you’ll have a fixed interest rate. That means your payment is going to be the same every month until you reach the final payoff for the loan. That amount is in addition to your monthly mortgage payment, so it is important to create a payment plan that will work within your budget.
You’ll also receive a lump-sum draw on your home equity with this loan to take care of expenses or projects that you have.
Although you do have the option to take a partial home equity loan, many HELOAN offers are for the full amount of what you have built. That means if your property values begin to decline, you could find that your home is under water, or that you owe more on it than it is worth, and it may stay that way for several years.
How to Get the Best Interest Rates
Whether you’re shopping around for a HELOC or a HELOAN, the first rule to consider for a great interest rate is to look at other lenders. More often than not, homeowners look to the holder of their mortgage for their home equity loan or line of credit. That is convenient, but it can also be very expensive.
Once you start looking at different lenders, you will discover that the markup rates will vary by a lot, especially when you’re thinking about a HELOC. The markup over prime can range from 1% to 4% – or even higher, depending upon your personal credit history.
That means if the prime rate is 4%, and your markup is 4%, then your interest rate on the HELOC will be 8%. Compare that cost to the debt you might already have. You may find that the costs of some HELOC offers are not beneficial to your budget.
You’ll want to talk to your lender about a rate cap. Some caps are in place over the life of the HELOC or HELOAN, if it is adjustable. Others may be for specific periods of time, like an adjustable-rate mortgage in structure. Look for as much stability in this lending product that is permitted with your credit. Locking in lower interest rates for as long as possible is the key to saving money.
Issues to Consider with a HELOC vs a HELOAN
With a home equity loan, your terms are generally locked once the loan has been approved. You know when payments will start, when they end, and how much you will pay each month. There is no wiggle room at all.
HELOCs can be very different. Although some HELOCs offer a lower interest rate, they do so because a balloon payment is required as part of the terms. You may be asked to provide a large, one-time payment at the conclusion of the HELOC, which may be difficult to make if you haven’t planned for it in advance.
A HELOAN provides you a lump-sum payment that you can use at your discretion. With a HELOC, you may choose not to use the credit you’ve been extended at all. Doing that will keep your equity value intact. It may also trigger what is called an “inactivity fee.” That fee means your charged for not using the HELOC, which means more money comes out of your pocket.
Many HELOCs give you the option to take a chunk of the line of credit, then lock in the interest rate for it, which makes it more like a HELOAN. In this situation, you might not be able to access that portion of the HELOC until the locked portion is completely paid off. If you lock $10,000 out of a $75,000 HELOC, for example, even if you pay off $7,000 of the $10k, you’d only have $65,000 available for use – not $72,000.
A final issue to look at is the prepayment penalty. If you decide to sell your home after taking out a HELOC, then you’ll need to pay it off. Some lenders will charge a prepayment fee to make up for the lost interest they expect to earn on the product.
One Final Thought About HELOCs vs HELOANs
If you’ve ever managed a credit card with a large spending limit, then you know how easy it is to spend a little over here, and a little more over there, until you’ve suddenly reached your credit limit. A HELOC operates in the same way, but it comes with severe consequences.
Spending in small increments with a HELOC is a fast way to drain the equity value you have in your home.
The same thing happens if you opt for a HELOAN instead. You take a lump-sum payment, then spend it here and there, until you suddenly run out of loan funds.
Now you’re left with a monthly payment, your mortgage payment, and other responsibilities too. If not properly managed, these lending products can lead you down a dangerous financial road.
That is why a HELOC or HELOAN should be used when there is something that you need which will increase in value over time. It may be wise to leave your equity alone to seek out alternative forms of financing too.
Every financial situation is different. A HELOC or HELOAN can provide you with access to credit or a loan when money is tight. If you plan on staying in your home for the next 2-5 years, then these products offer a number of potential benefits worth considering.
Compare the differences carefully to know which option might be the best one for you. Then consult with a professional financial advisor to ensure the best possible decision is being made.