Home Equity Loan vs HELOC: Understanding the Key Differences

Home equity loans and home equity lines of credit (HELOCs) allow you to tap the equity in your home for immediate cash. You can use that money for all kinds of large expenses, including home improvements, higher education, debt consolidation, small business investment, emergencies, and more.

You may have a lot of home equity

With home values rising sharply throughout 2022 and remaining elevated in 2023, many American homeowners are sitting on a lot of equity. According to a March 2023 report by CoreLogic, nationwide home equity was up 7.3% ($1 trillion) in the fourth quarter of 2022 compared to the fourth quarter of 2021. The average U.S. homeowner, meanwhile, gained nearly $14,000 in equity in 2022. 

So if you’ve seen your home’s value rise, you might be thinking about tapping into your equity. Two of the most common ways to do this are through home equity loans and HELOCs.

What is a home equity loan?

With a home equity loan — often referred to as a second mortgage — you can borrow money using your home as collateral. A mortgage lender provides the loan, and you receive the money as a lump sum. There’s usually a limit to the amount of money you can borrow: Most lenders allow up to 80% of the value of your home minus your primary mortgage balance. You can use that money in any way you see fit. 

A home equity loan has closing costs and a fixed interest rate that’s likely lower than what you’d get with other consumer loans and credit cards. Your payments are fixed, and you make them in addition to your mortgage payments (hence the label “second mortgage”). 

Home equity loan qualification criteria vary by lender. According to Experian, they typically include the following:

• A minimum credit score of 680. However, a minimum credit score of 720 is preferred. Lenders usually provide the lowest interest rates to those with the highest credit scores.
• A minimum loan-to-value (LTV) ratio of 80% for your primary mortgage. LTV ratio measures the size of your loan against the value of your property. An 80% LTV means you’ve built 20% equity in your home. Expect the lender to require an independent, professional appraisal to determine the value of your property. 
• A minimum debt-to-income (DTI) ratio of 43%. DTI ratio measures the size of your monthly debt payments against your monthly income.
• A strong history of making payments on time.
• Proof of homeowners insurance.

What is a HELOC?

With a HELOC, you tap your home equity through a revolving line of credit you can draw from as needed. As with a home equity loan, a HELOC is provided by a mortgage lender and your home is used as collateral. 

A HELOC is more flexible than a home equity loan. You draw money, up to your credit limit, and use it as needed. The draw period lasts for a set amount of time (such as 10 years), during which you're typically required to pay back only the interest on the money you've borrowed. After the draw period, a repayment period begins during which you'll have regular payments.

A HELOC provides revolving credit at much lower interest rates than a credit card. You may have an option for a lower introductory rate as well. Bank of America, for instance, currently* advertises a HELOC with a 6.24% rate for the first six months followed by an 8.9% variable rate.

According to Experian, HELOC requirements are similar to those of a home equity loan.

• A minimum credit score of 680; 720 is preferred.
• An LTV ratio of at least 80%, meaning you’ve built 20% equity in your home.
• A DTI ratio of at least 43%.
• Proof of income, demonstrating your ability to repay.

And as with a home equity loan, a lender will typically limit the amount you can borrow to 80% of the value of your home minus your primary mortgage balance.

*Accessed March 20, 2023

Here’s a summary of the key differences between a home equity loan and a HELOC:

When should you get a HELOC or home equity loan?

There are typically no restrictions on how to use a home equity loan or line of credit. Because they give you access to a significant amount of funds, they're ideal for large projects and other needs requiring a significant financial outlay. 

Lender Flagstar Bank suggests the following uses:

Home repairs and improvement — Projects that increase living space, renovate outdated spaces (such as kitchens or baths), or provide needed structural upgrades (such as a new roof), can add value to the home.

• High-interest debt consolidation — Credit cards, private student loans, car loans, and other personal loans often have high interest rates. You can use a home equity loan or HELOC to pay off those loans, then pay back the debt with a lower interest rate.
• Tuition payments — Home equity financing offers lower interest rates than available student loans. It might be an excellent option to pay for higher education.
• Major purchases — Tapping your home equity can be a good option if you’re hit with a significant unexpected expense, such as medical bills.

However you choose to use home equity financing, it's important to do so responsibly. Make sure you have solid financial habits already in place and have a plan to pay back the home equity loan or HELOC. The lender does not care how you use your home equity loan or HELOC. But it does expect to be paid back. And since your home is collateral, you risk losing it if you fail to make your payments. 

How do you get a HELOC or home equity loan?

You apply for a home equity loan or HELOC the same way you apply for a primary mortgage. Contact your mortgage lender to get the process started.

You'll be asked to provide documentation, including bank statements and pay stubs, to prove your ability to repay the loan. You'll authorize the lender to check your credit score and credit history. The lender will also arrange for an appraisal of your property to accurately determine the value of your home. 

Once approved, the lender will explain how you’ll receive or draw your funds and how you’ll repay. You may also have to pay closing costs. 

Home equity loan and HELOC pros and cons

Home equity loans and HELOCs are powerful tools to help you tap your home's equity for cash you can use in a wide range of ways. But you owe it to yourself to understand the pros and cons.

How to calculate your home equity

Calculating your home equity is simple math: Subtract your mortgage's balance from your home's current value.

Equity = Mortgage Balance - Home Value

To estimate your home's current value, visit a site such as Zillow.com and enter your address. You'll see the current, estimated market value of your home. Just remember that if you apply for a home equity loan or HELOC, the lender will require an independent appraisal.

Home equity financing example

Let's say you have a growing family and would like to hire a contractor to build an addition to your home. The addition will give you the living space you need while adding value to your property. 

You receive an estimate for $50,000 from a construction contractor to complete the work. You meet with your mortgage lender, discuss taking out a home equity loan for $50,000 and complete an application.

Your home’s value appraises at $400,000, while your mortgage balance is $175,000. The lender calculates your home equity by subtracting the mortgage balance from the home’s value. 

$400,000 - $175,000 = $225,000 home equity

The lender explains that you can borrow up to 80% of your equity.

$225,000 * 80% = $180,000

With your good credit score and low DTI, the lender approves your $50,000 loan application. You have a 7.0% fixed interest rate and a 120-month (10-year) repayment period. 

Monthly payment: $580.54

Total payment: $69,664.80

The lender transfers the $50,000 to your bank account so you can hire the contractor and get started on your home improvement project.

Frequently asked questions (FAQs)

Does a home equity loan require an appraisal?

Yes. An accurate understanding of your home's value is critical in your lender's calculation of your home’s equity. If you're applying for a home equity loan or HELOC, expect the lender to arrange an independent, professional home appraisal.

How have the Federal Reserve’s recent rate increases affected home equity financing products?

The Federal Reserve sets the federal funds rate, which banks charge each other for overnight loans. The prime rate, which banks use to base the interest rates for home equity loans and HELOCs, is typically three points higher than the federal funds rate. So as the Fed hikes the federal funds rate, we’ve seen an increase in the interest rates charged for home equity loans and HELOCs.

Can you have both a HELOC and a home equity loan?

Yes, you can have a HELOC and home equity loan simultaneously, provided you meet the lender's qualification criteria for each. Just remember that with each successive loan or line of credit, you’ll be tapping more of your home's equity. This will limit the amount you can borrow. 

Are rates lower on a HELOC or home equity loan?

Typically HELOCs offer lower interest rates than home equity loans.

How can I use the money I get from a home equity loan or HELOC?

You can use the money you get from a HELOC or home equity loan in any way you see fit — there are no lender requirements. Popular uses are for home improvement projects, debt consolidation, and to pay for higher education or emergency expenses.