What Is a Home Equity Loan or HELOC?

If you've owned your home for a while or have seen its value rise significantly, you might be thinking about taking out a loan against the equity, perhaps for home improvements, a new car, or some other purpose. You have two basic choices: a home equity loan or a home equity line of credit (HELOC).

Both options can be useful tools for financing major expenses. But it's vital that you understand the risks involved. These loans are secured by your home. So, if you fail to repay them, you could end up in foreclosure. Before you decide to take out one or the other, carefully consider the terms and your financial situation.

Introduction to Home Equity Loans and HELOCs

Home equity loans and HELOCs are common financial products allowing a homeowner to tap into the equity in their home. Here's a brief explanation of each type of loan with more information below.

Home Equity Loans in a Nutshell

A "home equity loan," often called a "second mortgage," provides a lump sum of money that the borrower repays over a fixed term, typically with a set interest rate (but not always).

HELOCs in a Nutshell

On the other hand, a HELOC is a revolving line of credit that the borrower can draw upon as needed up to a maximum amount over a certain amount of time (called a "draw period"). HELOCs sometimes have annual maintenance fees and many have cancellation fees.

What Is Home Equity and How Does It Impact Home Equity Loans and HELOCs?

With a home equity loan or HELOC, you borrow against the value of your home decreased by the existing mortgage. Your home's value minus the existing liens equals your equity.

You can't borrow more than the amount you have in equity. In most cases, you'll be limited to borrowing up to a percentage of the equity you have in the home.

How Home Equity Loans and HELOCs Work

A home equity loan or HELOC is a loan that uses your house as collateral, just like your primary mortgage.

Qualifying for a Home Equity Loan vs. a HELOC

With a home equity loan, most lenders won't allow you to borrow more than 75% to 80% of the home's total value, after factoring in your primary mortgage.

Similar to home equity loans, the amount of money you can borrow with a HELOC is based on the amount of equity you have. Usually that means you will be able to borrow some percentage of the home's value, reduced by the existing mortgage, usually 75% to 80%.

And, of course, you'll need to meet the lender's credit requirements.

Repayment Terms for Home Equity Loans and HELOCs

The loan term of a home equity loan is usually much shorter than that on a primary mortgage, 10 to 15 years is common. That means that your monthly payments will be proportionally higher, but you'll pay less interest overall.

For a HELOC, the repayment period will usually be in the 10- to 20-year range, which means that, as with a home equity loan, you'll pay less interest than you would on a traditional 30-year fixed mortgage, but your monthly payments will be proportionally higher. The draw period is usually 5 to 10 years, during which you pay interest only on the money you borrow. At the end of the draw period, you'll begin paying back the loan principal.

Application Process for Home Equity Loans and HELOCs

Shopping for a home equity loan or HELOC is just like shopping for a primary mortgage. You can go to a mortgage broker or research loan options on your own. Once you find a loan you like, you'll have to fill out an application and meet credit requirements.

Cost of a Home Equity Loan or HELOC

With a home equity loan, expect to pay some of the typical fees you paid on a regular mortgage, but in much lesser amounts. (Some of these fees are based on the loan amount, which is probably lower than your primary mortgage.) At the very least, you'll probably have to pay for an appraisal, which is the lender's opportunity to evaluate how much your home is worth. You might find a home equity loan without any fees, but be careful: Usually it means these costs are rolled into the loan, perhaps in the form of a higher interest rate.

Costs on HELOCs are usually low, but variable interest rates mean the interest payments can be much higher.

Fixed vs. Variable Interest Rates: Home Equity Loans and HELOCs

A fixed interest rate stays the same over the life of the loan. With a fixed interest rate, you'll have the same monthly payment for the entire time you have the loan. A variable interest rate, on the other hand, can change periodically based on the market index. So, your payment might go up or down. Variable rates usually start out lower than fixed rates, but will probably increase over time.

Interest rates for home equity loans are often fixed, but not in all cases. HELOC interest rates are usually variable and tied to the prime rate, reported in The Wall Street Journal, and the maximum rates are often very high.

Because the risk of not getting paid the full value of the loan is slightly higher for the second lender, interest rates on home equity loans and HELOCs are usually higher than those on primary mortgages. However, at least the interest rate is usually lower than that of a typical credit card.

What Can You Do With a Home Equity Loan or HELOC?

You can do whatever you want with a home equity loan or HELOC: finance your child's education, take an extravagant trip, or buy a big screen television. Some people use it to consolidate debts that they've racked up on various credit cards. (However, turning unsecured debt, such as credit card debt, into secured debt, like a mortgage, usually isn't a good idea. If you default on payments, you could lose your home.)

The most prudent way to spend the cash is on improving your home. If you aren't able to pay the loan back, you risk foreclosure, but if you used the cash to improve your home, you should see an increase in its value. This gives you the option to refinance if you need to and, if the value of your home has gone up, you'll be more likely to qualify for the loan. Moreover, you might be able to deduct the home equity loan or HELOC interest if the loan money is spent on the home, but not for other purposes.

HELOCs work well if you're making improvements to your home and have ongoing expenses. Often, borrowers get them as an added safety net, in case they need cash suddenly, but without real plans to draw on them otherwise.

You might just want to have this source of cash in your back pocket for emergencies. But make sure there's no requirement that you draw some amount, as some lenders require this so that they're assured of making a little money on the deal.

Tax Implications of Home Equity Loans and HELOCs

A final benefit to using a home equity loan or HELOC to improve (or even purchase) a home is that the interest can be tax deductible, just as it is on a primary mortgage. However, the Tax Cuts and Jobs Act (TCJA), the massive tax reform law that went into effect in 2018, placed new restrictions on this deduction.

Before 2018, you could deduct the interest on up to $100,000 in home equity loans or HELOCs. You could use the money for any purpose and still get the deduction—for example, homeowners could deduct the interest on home equity loans used to pay off their credit cards or help pay for their children's college education. The TCJA eliminated this special $100,000 home equity loan deduction for 2018 through 2025.

However, the interest you pay on a home equity loan or HELOC used to purchase, build, or improve your main or second home remains deductible. The loan must be secured by your main home or second home. So, for example, you can deduct the interest on a home equity loan you use to add a room to your home or make other improvements.

Such a home equity loan or HELOC counts towards the annual limit on the home mortgage interest deduction. If you purchased your home before December 15, 2017, you may deduct mortgage interest payments on up to $1 million in total loans used to buy, build, or improve a main home and a second home. If you purchased your home after December 15, 2017, you may deduct the interest on only $750,000 of home acquisition debt. The $750,000 loan limit is scheduled to end in 2025. After then, the $1 million limit will return. These numbers are for both single taxpayers and married taxpayers filing jointly. The maximums are halved for married taxpayers filing separately.

Also, you may deduct mortgage interest of any type only if you itemize your personal deductions on IRS Schedule A. You should itemize only if all your personal deductions, including mortgage interest, exceed the standard deduction. The TCJA roughly doubled the standard deduction. As a result, only about 14% of all taxpayers are able to itemize, down from 31% in past years. If you're one of the 86% who don't itemize, the home equity loan and HELOC interest deduction won't benefit you.

What Are the Pros and Cons of Home Equity Loans and HELOCs?

Home equity loans and HELOCs offer homeowners some advantages, but they also come with potential drawbacks. The primary upside is the ability to get a large sum of money at relatively low interest rates compared to unsecured loans, such as a personal loan or credit card. Also, the interest you pay might be tax-deductible.

But these loans are secured by your home. So a major downside is that a failure to make payments can result in foreclosure.

Choosing Between a Home Equity Loan and a HELOC

Again, home equity loans generally provide a lump sum with fixed payments, offering predictability but less flexibility. HELOCs, on the other hand, provide a revolving line of credit with variable rates, offering flexibility but also the potential for fluctuating payments. So, you'll need to decide if you want the certainty of a fixed rate and consistent payment amount or if you prefer initial lower payments but are willing to risk an increased rate in the future, which would increase your payments.

Understanding the pros and cons, as well as evaluating your financial need and circumstances, is essential for making an informed decision that lines up with your financial needs and tolerance for risk.

Get More Information

To learn more about home buying, read Nolo's Essential Guide to Buying Your First Home, by Ilona Bray and Ann O'Connell (Nolo).