Should I get a home equity loan or a HELOC?

A home equity line of credit (HELOC) and a home equity loan are two ways to leverage the equity in your home to finance or pay off a big purchase. Equity is the difference between what you owe on your house and the house's fair market value. Both use your home as collateral on the loan or line of credit. If you don't pay it back, you could go through foreclosure on your home, so this is a decision you should not make lightly.

However, having your home as collateral could mean getting a lower interest rate than you would from unsecured loans or credit cards. You may ask yourself, "Should I get a home equity loan or a HELOC?" Examine some of the main differences between the two and some cases where one is better than the other to make the right choice for your situation.

What is a HELOC?

A HELOC differs from a home equity loan in that it's a revolving line of credit that is similar to a credit card. You can borrow as much or as little as you need against the entire credit line and with an interest-only HELOC. You can make interest-only payments on what you borrow during the draw period. It's similar to a home equity loan in that you can typically only borrow against 80% to 85% of your equity. However, the interest rate isn't fixed. Rather, it is based on the current federal interest rate plus a specific number of points.

Your interest rate could go up or down depending on the financial market. A HELOC has two phases: The draw phase and the repayment phase. During the draw phase, you can withdraw money against the line of credit, and you can use as much or as little as needed. With an interest-only HELOC, the only payment required is the monthly interest due. You can pay more if you'd like, but you're only responsible for the interest. The draw phase is typically five years or less. You can refinance and perhaps extend your draw phase; otherwise, you'll enter the repayment phase.

The repayment phase is usually in the 15- to 25-year range and consists of regular monthly payments covering interest and principal. You can think of this arrangement as a home equity loan or a mortgage.

To summarize the benefits, you only borrow what you need and can do so without reapplying. Since the amount you can borrow is based on equity, getting a HELOC on a newly purchased home may not make sense. Like a home equity loan, a HELOC may be tax-deductible when applied to home renovations. Please consult your tax advisor regarding interest deductibility as tax rules may have changed. However, you want to be careful about having access to a potentially significant credit line to avoid being tempted to overspend.

What is a home equity loan?

A home equity loan is a large lump sum payment based on a percentage of the equity in your home. The general rule is that lenders allow about 80% to 85% of the equity in your home as the maximum amount you can borrow. For example, if you have $50,000 in equity, you could get between $40,000 and $42,500 in a home equity loan. Once you have applied and supplied all the necessary documentation and are approved, you will get the amount in one lump sum. The loan term can vary between five and 20 years, occasionally stretching out to 30 years as a standard mortgage would.

The loan's interest rate is fixed throughout the life of the loan, as is the monthly payment, making it easier to budget every month. Other benefits allow you to pay it off quickly to get rid of debt faster or over up to 30 years to make it more affordable while providing much lower interest rates than credit cards or personal loans. Also, if you use your home equity loan for qualified home renovations, you may be able to deduct the interest paid from your taxes.  Please consult your tax advisor regarding interest deductibility.

Defaulting on your home equity loan could result in foreclosure. A home equity loan adds another house payment to the monthly mortgage you're already paying, adding additional financial obligations. The interest rate is fixed, but it can run higher than a HELOC rate.

Another point to consider is that if you borrow against too much of your equity, you could run into issues if your property values decline. Finally, as with your first mortgage, a home equity loan involves closing costs and other fees.

How do you choose between a HELOC and a home equity loan?

"Should I get a home equity loan or a HELOC?" Before you answer this question and decide, you must consider several factors:

Home equity loan

• You know precisely the amount you need to borrow.
• You want a lump sum upfront.
• You want fixed payments.
• You have a good credit score.

HELOC

• You want flexibility in the amount you wish to borrow or how often you can borrow against that amount.
• You know you will have some expenses coming up but do not know exactly how much, such as renovating a bathroom, which can add unplanned expenses.
• You want the lowest interest rate possible since HELOCs trend lower than a home equity loan.
• You have a strong credit score. Lenders typically look for scores over 700 when approving applications.
• You know what to expect as far as the interest rate fluctuations, and you won't feel overwhelmed by the increases that may happen.

How do you apply for a HELOC or home equity loan?

The application process for a home equity loan and home equity line of credit is very similar. Before starting the application, you can streamline the process through these steps:

• Check your credit report: Take a look at your credit history. If you discover discrepancies, you can dispute them. If your credit score isn't as high as you'd like it to be or need it to be, you can work on reducing your debt or making future payments on time.
• Get documentation together: During the application process, you'll need to provide several documents, including tax returns, pay stubs, W-2s, tax statements, homeowner insurance information, and mortgage information.
• Complete the application: You'll provide your personal information, such as your home address, phone number, employment history and existing debt.
• Get an appraisal: Your home will need to have a current appraisal, which means that you will need to pay for and have your home's value assessed at the time of application. You often cannot roll this fee into the loan.
  Expect to pay approximately $500 out of pocket for this step in the process.
• Wait for approval: Underwriting can take 30 to 45 days to review your credit history, income verification and appraisal. Once underwriting has approved your home equity loan or HELOC, you can expect to close within a month.
• Closing time: Your financial institution will go over all the documentation of your home equity loan or HELOC with you as you sign the required documents.
• Withdraw or accept funds: Once your HELOC gets approved, you can start drawing from your credit line. Or, if you have a home equity loan, you'll receive a lump sum at closing.

Unlock the value of your home

An Alliant HELOC could help you get the funds you need when you need it. Pay for a home renovation, vacation home and more.

Want to learn more about HELOCs? Read these additional articles:

• How does a HELOC work?
• Paying for a big expense: personal loan, HELOC or card