Home equity line of credit (HELOC) vs. home equity loan: How does each work?

Home equity lines of credit (HELOCs) and home equity loans are two methods of borrowing money against the ownership stake you have in your home. Both typically allow you to tap up to 80 or 85 percent (or sometimes even more) of your home’s value, minus your outstanding mortgage balance.

Let’s look more closely at how HELOCs and home equity loans work, and how to determine which would work best for you.

Key differences between HELOCs and home equity loans

Pros and cons of a home equity loan

Pros and cons of a HELOC

Why are HELOCs and home equity loans popular now?

Before we get into more details, a brief look at the home equity lending scene today.

HELOCs and HE Loans have blossomed in popularity in recent years. True, originations of home equity loans were down 8 percent year over year (from Q4 2022 to Q4 2023) according to TransUnion’s most recent “Home Equity Trends Report,” and their HELOC cousins declined 29 percent in the same period. But this slowdown is somewhat deceiving. Compared to earlier years, home equity originations are well above the figures recorded in the last six years.

What’s the appeal? Starting in mid-2022, the RIIR (the rise in interest rates) — particularly mortgage rates, which have doubled since their mid-pandemic lows — have decimated the appeal of cash-out refinancing, once the go-to way to tap a homeownership stake. Hence, the interest in home equity loans and HELOCs. While these products’ rates have risen in recent years too — HELOCs in particular ended 2023 above 10 percent — they’ve stabilized and even dropped in 2024. Looking to the future, HELOC rates are projected to decline even further, potentially averaging about 8.45 percent by the end of this year.

Of course, all this home-equity borrowing is made possible by the record-setting rise in home prices since the start of the pandemic, which has increased the value of homeowners’ equity stakes. The average mortgage holder now has $206,000 in tappable equity, up from $185,000 a year ago, according to ICE Mortgage Technology, a real estate data analysis firm.

How can you use home equity?

Both home equity loans and HELOCs allow you to use the funds however you see fit. Many borrowers use them to pay for major home repairs or renovations, like finishing a basement, remodeling a kitchen or updating a bathroom. Others use them to pay off high-interest credit card debt, start a business or cover college costs.

So, how much money can you borrow with a home equity loan or HELOC? In many cases, quite a bit. Lenders often set minimums of $10,000 with these tools, and maximums can run into six figures.

The exact amount you can borrow, though, will depend on a few factors, including your equity stake and the maximum equity percentage that your lender will let you borrow. Your mortgage balance also plays a role, because your lender usually requires your overall home-debt load to stay below a certain percentage of your home’s value.

For example, let’s say your home is valued at $350,000, and you still owe $150,000 on your mortgage. This means you’ve built $200,000 in equity — but it doesn’t mean you can access that full amount.

If your lender says that your debt needs to remain below 80 percent of your home’s value, that’s a cap of $280,000. Subtract your remaining mortgage balance from that, and you’re left with a tappable equity amount of $130,000. It’s still a substantial sum, but perhaps not as much as you envisioned.

Requirements for HELOCs and home equity loans

Each lender has its own eligibility criteria for home equity loans and HELOCs. However, here are some general guidelines to keep in mind:

• Credit score: A credit score of 640 could be enough with some lenders, but aim for 700 or higher to have the best approval odds (and get the best interest rates).
• Income: Your income should be consistent and verifiable.
• Debt-to-income (ratio): You’ll need an acceptable DTI to qualify for funding.
• Equity: Lenders generally allow you to borrow from 80 and 90 percent of your home equity, which is the difference between your home’s value and what you owe.
• Appraisal: The lender will require an appraisal to determine how much your home is worth or its fair market value. (Note: The appraisal is arranged by the lender, and the fee is included in the closing costs).

Obtaining a home equity loan or line of credit

How to obtain a home equity loan

Home equity loans are available through banks, credit unions and online lenders. Some offer online prequalification tools that let you view loan offers with estimated monthly payments and terms without impacting your credit score.

If you decide to formally apply, you can typically start the process online and upload the requested documentation to get a lending decision. You can also visit a branch if you’re doing business with a traditional bank or credit union. Either way, formally applying for a home equity loan will result in a hard pull that impacts your credit score.

Note: Home equity loans come with a three-day cancellation rule, aka the right of rescission. It allows you to back out of the contract without penalty within three business days.

How to obtain a HELOC

The process for obtaining a home equity loan and HELOC are similar, as are the qualifications. However, HELOCs may be harder to get in some cases, with more stringent criteria. For example, peer-to-peer lender Prosper sets a 660 credit score minimum for HELOCs, vs. 640 for home equity loans.

The three-day right of rescission rule also applies for HELOCs. That said, the funds disbursement method varies between the two, as mentioned above.

Am I able to get a home equity loan or HELOC with bad credit?

Even if you have less than ideal credit, it’s still possible to obtain a home equity loan or HELOC. It’s not likely that you’ll get the most competitive interest rate, but if you have reliable income and a relationship with a lender, you could qualify for a loan.

There are also lenders that will approve home equity loans and HELOCs for borrowers who have FICO scores as low as 620, provided that you meet other requirements related to debt levels, equity and income.

In addition to a credit score of at least 620, in order to earn approval, you’ll likely need about 15 percent to 20 percent equity in your home and a maximum debt-to-income (DTI) ratio of 43 percent, or up to 50 percent depending on the lender. Lenders also like to see an on-time mortgage payment history.

Choosing between HELOC and home equity loan: Which is right for you?

How to decide between a home equity loan and a HELOC? Ask yourself these questions.

What’s the nature of your need?

A home equity loan could be a good fit if you know what you’ll use the funds for, when you’ll need them and exactly how much you’ll need. However, a HELOC could work better if you don’t know exactly the total expense you’ll incur, and/or you’ll need to keep a ready source of funds on hand. Or, if your costs will extend over a long period of time (like paying a home contractor in installments, or college tuition for four years).

Are you a set-it-and-forget-it type?

Do you prefer predictability in your obligations? A home equity loan is ideal if you like a fixed interest rate and monthly payment that won’t ever change. And you’re not an interest-rate watcher.

A HELOC on the other hand, could be ideal if you hate the idea of being locked into a higher-than-market interest rate, or paying interest on money you haven’t spent. You don’t mind — and have the means to cover — fluctuating payments.

Are you disciplined?

HELOCs can be a slippery slope to more debt than you can handle if you only repay the interest during the draw period and none of the principal. Taking this approach can cause sticker shock when the HELOC repayment phase begins and you have a substantial debt left to repay. Unless you expect to come into a significant sum of money or windfall in the future, it’s a good idea to pay both principal and interest during the draw period on a HELOC, and not give in to the temptation of minimal, interest-only payments.

If that’s not you, a home equity loan might be a better choice, as it imposes a repayment schedule on you, similar to your mortgage. It helps to prevent the debt from becoming unmanageable.

Bottom line on home equity loans and HELOCs

Home equity loans and HELOCs both allow you to borrow money against your home equity, but they’re not the same. Consider the purpose of the funds, how much you need and whether or not you’ll want to borrow more in the future.

For example, if you want an upfront lump sum and a predictable repayment schedule and sums, then a home equity loan might be the right choice. The trade-off is that you’ll need to know exactly how much you want to borrow; otherwise, you could end up with more or less than you need. But if you do, say to settle a bunch of credit card bills, then the loan could be ideal.

On the other hand, if you’re unclear on how much financing you’ll need or want the option to take out more money as you need it — and only incur interest on an actual withdrawal — then a HELOC might be a better option. But you need to be disciplined in paying off the principal and be prepared for swings in your monthly payments.