Home Equity Loan vs HELOC
Compare two options for accessing home equity side-by-side.
Home is where the heart is, but for most Canadian’s it’s also the heart of your investment portfolio. It’s a valuable asset that you can strategically use to your advantage. You just have to make sure you take steps to protect that investment. Otherwise, you increase your risk of foreclosure. This is what you need to know when comparing a home equity loan vs HELOC.
What is a home equity loan? What is HELOC?
A home equity loan is a fixed-rate loan that allows you to borrow against the equity built up in your home. You receive a lump sum of cash that you pay back in installments. You generally must pay another round of closing costs to take out the new loan.
By contrast, a HELOC is Home Equity Line of Credit. Instead of taking out the full amount at once, you have an open credit line you can borrow against during a withdrawal period. There’s still a set limit to how much you can withdraw, but you take the funds out as needed anytime before the withdrawal period ends.
In general, most HELOCs are adjustable rate financing tools. You typically pay interest only for 10 years, then you pay back the principal (what you withdrew) after 10 years. This means payments “balloon” at the 10-year mark.
Home equity loan vs HELOC: A side-by-side comparison
|Home Equity Loan||HELOC|
|Fund disbursement method||Single lump sum||Withdraw from credit line as needed|
|Monthly payments||Fixed installments, covering principal plus interest||Interest-only for 10 years, then payments balloon|
|Interest payments tax deductible?||Yes||Yes|
|Increased foreclosure risk?||Yes||Yes|
One of the biggest advantages of a HELOC is the ability to borrow only the funds you need. With a home equity loan you receive all the money at once. A home equity line of credit allows you to withdraw only what you need. This can be more useful, especially depending on what you want to use the funds to do.
For example, let’s say you want to use your home’s equity to fund a renovation project. If you take out a loan, you may not end up using all the funds you took out. Or worse, you may go over budget and not have enough money. With a HELOC, you can withdraw money as the project progresses. This avoids overages and undercutting your budget.
Comparing the cost of a home equity loan vs HELOC
Upfront, a HELOC costs less because you don’t have to worry about covering closing costs. Closing costs of a home equity loan generally range from 3-5% of the amount financed. So a home equity loan generally costs more to set up.
A HELOC may also start out with a lower interest rate, because the rate is adjustable. However, you have to worry about economic fluctuations. If the government raises benchmark interest rates, the rate on your HELOC almost always increases, too. With a home equity loan, you lock in the rate at the time you take out the loan. You don’t have to worry about market fluctuations.
This means that the total cost of a HELOC is difficult to assess ahead of time. If rates stay low, then the cost of a HELOC overall may be less. But only if rates stay low. With home equity loans, you can at least know what the total cost will be upfront.
Balloon payments can become a burden
Another advantage of a home equity loan is you never have to wonder what your payments will be next year. You pay off principal and interest from the outset. The payments stay fixed from the first to the last.
On the other hand, home equity lines of credit are interest-only for 10 years. That keeps your initial payments low, but it means you have a notable increase 10 years into repayment. Once the withdrawal period ends and the repayment period begins, the monthly amount may bust your budget.
And remember, HELOC interest rates adjust with the market. If your 10-year balloon payment goes into effect in a year where rates increase, a HELOC can get out of control quickly. This leads to a risk of default and subsequent foreclosure actions.
Repaying HELOC principal earlier
It’s important to note that you can choose to make a principal repayment during the withdrawal period. This will reduce next month’s interest expense and increase the available credit line during the draw-down period. It also may minimize the amount you need to repay once with withdrawal period ends.
Once it does, the loan payment typically becomes self-amortizing over the remaining loan term. That means that the minimum monthly loan payment is no longer interest only. The payment is sized so that monthly payments over the remaining loan term are large enough to both cover the interest expense and to pay off the loan.
If you have a HELOC with a 20-year term and a 10-year draw, after 10 years the loan becomes self-amortizing over the remaining 10-year repayment period and you can no longer draw against the line of credit.
Always keep foreclosure risk in mind
Whether you take out a home equity loan or HELOC, it’s important to understand both increase your foreclosure risk. Your home is the collateral used to secure the financing you receive. So, if you fall behind on the payments, the lender is within their rights to start a foreclosure action. That’s true for a home equity loan, as well as a home equity line of credit.
As far as which option has a greater risk of foreclosure, it depends. The financial burden of a home equity loan is higher overall. The monthly payments that cover both interest and principal may burden your budget. However, once you get used to making the payments, your budget should balance out. Unless you lose your job or have a major life event, there should not be an issue.
With a home equity line of credit, the burden upfront may be less. Most people don’t have any issue with a HELOC when it’s interest-only. However, you may hit a financial cliff in 10 years once you start to repay the principal.
Always consult a HUD-certified professional before you borrow!
If you want to access equity in your home, always consult with a professional first. You can call 1-844-402-3073 to speak to a counsellor at no charge. Together, you can review your budget and decide on the best option for your finances moving forward.