Thanks to rising home values, the average U.S. homeowner gained nearly $10,000 in home equity in 2018 alone. That’s the kind of trend that leads to a bump in home improvement spending—something that reached a new high by the end of 2018.
When it comes to home improvements, many homeowners turn to home equity loans and home equity lines of credit to help them pay for the work. What's the difference? Here's the breakdown:
What are Home Equity Loans and Lines of Credit?
In a nutshell, home equity lines of credit (or HELOCs) and home equity loans allow you to use the equity in your home to get a loan. You can typically borrow up to 85% or 90% of the value of your home, and terms are usually pretty favorable. Because the loan is based on your home equity, your home is your collateral.
What's the Difference Between Them?
Much of the difference between a home equity loan and HELOC comes in the form of distribution. Home equity loans are disbursed in a lump sum, as with a traditional loan. You take out a loan for a certain amount and agree to loan terms such as the length of the loan, the interest rate and your monthly payment. The interest rate on a home equity loan is fixed.
A HELOC, on the other hand, operates more like a credit card. When you open a home equity line of credit, you have access to a specific amount of funds that you can borrow. You might open a HELOC and never use any of the funds available to you, or you can borrow up to the limit of your line of credit during the draw period, or the period of time in which funds are available, then repay what you’ve borrowed over time. The interest rate on a HELOC is usually variable, meaning your payment will increase or decrease as rates fluctuate.
When to Use a Home Equity Loan
Home equity loans are most useful in the following situations:
- You have a project in mind. If you have a distinct spending need, being able to withdraw a lump sum at a fixed interest rate is helpful.
- You want a fixed interest rate. If variable interest makes you antsy, a home equity loan offers predictability with a set term, interest rate and monthly payment.
- You want to consolidate debt. If you’re looking to combine several monthly debt payments into one payment at a fixed rate, a home equity loan can allow you to do this.
When to Use a Home Equity Line of Credit (HELOC)
HELOCs are better suited to the following uses:
- You’re doing a home improvement project in stages. If you’ll need a large sum of money, but you won’t need it all at once—such as a home renovation that happens in pieces—a HELOC may be the better choice since you can borrow the money in chunks.
- You aren’t sure how much money you need. If you have a cash need—or the potential for a cash need—but you aren’t sure of the total amount, a HELOC gives you more flexibility.
- You need a safety net. Entrepreneurs and small business owners sometimes open a home equity line of credit as an extra emergency fund in case they find themselves in a tight spot—because once you’re in the tight spot, borrowing money isn’t always easy.
Home Equity Pitfalls
You don’t have to tap your home equity just because it’s there—and if you do, make sure you do it wisely. Avoid the following mistakes:
- Using it for everyday expenses. In one Bankrate survey, about one in six homeowners said they think paying regular household bills was a “good use” of home equity. But if you’re taking on debt to pay for normal household costs, that’s a sign that money’s too tight. (Plus, if you don’t use the money for household repairs, you can’t deduct the loan interest on your taxes.)
- Being casual about missing payments. Your home is your collateral for a home equity loan or HELOC. That means if you default on this loan, you could lose your house.
- Borrowing heavily before a move. If you’re not going to be in the home for several years, borrowing a hefty amount of your home equity can put you in a bad position if home values go south. You could end up owing more on the home than it’s worth, which makes it very difficult to sell.
The Bottom Line
Both home equity loans and HELOCs are effective ways to leverage the equity in your home for improvement projects and other repairs that can boost the value of your home. If you’re unsure of which to choose, talk to a Fifth Third advisor about which type of loan might be most appropriate for your situation.