HELOC vs. home equity loan: Which is a Better Way to Finance Your Next Renovation Project?

You’ve probably heard of a Home Equity Loan and home equity line of credit (HELOCs) - but you’re still trying to figure out how useful they could be towards financing major purchases like that home renovation project you’ve been planning - right?

Well, you’ve come to the right place! 

HELOC and Home Equity Loans are considered the smartest way to pay for home improvements like a bathroom remodel, kitchen renovation, or home additions. Often homeowners use HELOCs to finance major renovation projects, as the interest rates are lower than they are on personal loans and credit cards. That’s because you can continually build equity as you live in your home and then access your home equity when you need it with a home equity loan or HELOC.

In short, Both are financing options that allow you to borrow against the equity in your home. Still, there are two distinct major differences: HELOCs (home equity line of credit) offer financing via a line of credit, while Home Equity Loans offer financing via a lump sum. A home equity loan is an alternative to the HELOC, and there are several important differences between the two options.  

 But, that’s not all! 

There are many other unique differences between a Home Equity Loan vs Home Equity line of credit that you must know if you’re considering these financing options.

We’ve created this expert guide to help you understand the difference between HELOCs vs Home Equity Loans, how to use home equity loans and HELOCs for home improvement, how they work for financing renovations, and how much you can borrow.

What Is a HELOC?

A HELOC  means home equity line of credit and is designed as a revolving line of credit. HELOCS  work by offering an available credit limit determined by your home’s value, the amount owed on the mortgage, and the lender’s criteria. There are a few requirements that you’ll need to qualify for a HELOC, however, they will vary depending on your lender. HELOCs have variable rates, rather than fixed rates. This means that your interest rates will fluctuate depending on the market as you’re paying back your loan. HELOCs generally have two phases - the draw phase and the repayment phase. The draw phase generally lasts around 10 years and is the time when you can use your line of credit whenever you’d like.

The biggest advantage of using a home equity line of credit is the flexibility to access more funds as you need it (during your renovation), and a longer window to start repayment. The biggest disadvantage is the potential to pay back more than you expected from your lender due to the variable interest rate.

HELOC Pros vs Cons

Renovation Loan Expert Tip: It’s important to note that while a HELOC can offer flexibility and potential cost savings, it also comes with risks, such as variable interest rates that can rise over time and the possibility of borrowing more than you can afford to repay. While it is uncommon, some banks will offer fixed-rate HELOCs, or partial fixed-rate HELOCs, where you can turn a portion of your HELOC balance into a fixed-rate loan once you start to draw from your line of credit. Oftentimes, these fixed-rate HELOCs will have higher starting interest rates than variable-rate HELOCS, or additional fees, but it depends on the lender. Still, there are some HELOCs with low-interest rates, like the RenoFi HELOC which can help offset the effects of rising interest rates for lengthy renovation projects.

What Is a Home Equity Loan?

 A Home Equity Loan is a type of lump sum loan that allows homeowners to borrow money using their home as collateral. Home equity loans are considered “second mortgages,” as they are second in position compared to your first mortgage. A Home Equity Loan works by allowing you to borrow a lump sum against your home’s value. Technically, you can use the lump sum of money that you get from a Home Equity Loan for anything, but it is typically used for home improvement projects, paying for college, medical expenses, debt consolidation, and business or wedding expenses. 

The biggest advantage of using a Home Equity Loan is the fixed low-interest rates. Since interest stays the same throughout the loan term, the monthly payment will be the same each month, and easily manageable for a tight budget. The biggest disadvantage of using a Home Equity Loan is the potential run out of funds if the lump sum is mismanaged or you run into an unexpected need for more funds (which is very common during home improvement projects). 

Home Equity Loan Pros vs Cons

Similarities Between a Home Equity Loan vs HELOC?

Both are secured loans that use your home as collateral: Both HELOCs and Home Equity Loans are secured loans, which means that they are backed by the value of the home. If the borrower fails to repay the loan, the lender can foreclose on the property.

Both use home equity to help determine loan amount: HELOCs and Home Equity Loans both allow homeowners to borrow money based on the equity in their home. Equity is the difference between the current market value of the property and the outstanding mortgage balance.

Both have tax benefits: Interest paid on both HELOCs and Home Equity Loans may be tax-deductible, up to a certain limit, if the funds are used for home improvements.

Both require home equity and good credit: Both HELOCs and Home Equity Loans typically require homeowners to have a certain amount of equity in their property and a good credit score in order to qualify for the loan.

Both can be used for a variety of purposes: Both HELOCs and Home Equity Loans can be used for a variety of purposes, including home improvement projects, debt consolidation, and other major expenses.

Differences Between a HELOC vs Home Equity Loan?

Interest rate structures are different: HELOCs typically have variable interest rates, while Home Equity Loans usually have fixed interest rates. This means that the interest rate on a HELOC can change over time based on market conditions, while the interest rate on a Home Equity Loan remains the same throughout the life of the loan.

Repayment terms vary drastically: HELOCs usually have a draw period of 5-10 years, during which the borrower can access the available credit as needed and only make interest payments on the amount borrowed. After the draw period ends, the borrower enters a repayment period and makes monthly payments on the outstanding balance, which includes both principal and interest. Home Equity Loans, on the other hand, have a fixed repayment period with equal monthly payments throughout the life of the loan, but repayment starts almost immediately.

Credit limits are larger with HELOCs: HELOCs typically have a higher credit limit than Home Equity Loans, which can be tempting to use for non-essential purchases or to overborrow for renovations. This can result in higher debt and longer repayment periods.

They are considered different types of debt: A HELOC is a type of revolving debt, similar to a credit card. It provides borrowers with a credit limit based on the equity in their home, and they can borrow and repay funds as needed during the draw period. Interest is charged only on the amount borrowed and not the entire credit line. On the other hand, a Home Equity Loan is a type of installment debt, similar to a traditional mortgage. It provides borrowers with a lump sum upfront that they must repay over a set term with a fixed interest rate and monthly payments. The difference in the type of debt matters because it affects how interest is charged and how funds are repaid.

Using Equity To Finance Home Improvements

Using equity to finance a home renovation project can be a smart move. But you need to understand how it works to be able to figure out your best financing option. Despite their differences, both HELOCs and Home Equity Loans are extremely popular financing options for a home renovation.  **The most important thing to know about using a home improvement line of credit or home equity to finance renovations is that you are borrowing against the value of your home, and your home is considered collateral. It’s important to make sure that you find lenders offering the lowest interest rates to ensure you can afford the payments.

The bigger the difference between the amount you owe on your mortgage and the value of your home, the more equity you’ve got. And as you continue to make monthly payments, your mortgage balance decreases, and your equity increases.

So let’s start by looking at the different options that you’ve got for tapping into your home’s equity for home improvements:

• Home equity loan
• Home equity line of credit (HELOC)
• Cash-out refinance

* Renovation Loan Expert Tip:* These are secured loans that use your home as collateral, meaning that you could lose this in the event that you are unable to make payments. We encourage you to start by using a personalized home improvement Loan Calculator to see how much you can borrow.

Comparing HELOC vs Home Equity Loan vs Cash-Out Refinance

Best Uses: HELOC and home equity loans are specifically designed for home improvement projects or other major expenses, while a cash-out refinance can be used for any purpose, such as consolidating debt or financing an investment property. 

Interest rates: HELOCs and home equity loans typically have higher interest rates than cash-out refinance because they are considered riskier for lenders. However, the interest rates on all three options can vary depending on factors such as credit score, loan amount, and home value.

Repayment terms: HELOCs and home equity loans typically have shorter repayment terms than cash-out refinances. HELOCs typically have a draw period of 5-10 years, during which you can withdraw funds as needed and only pay interest on what you use. After the draw period ends, you enter a repayment period of 10-20 years, during which you must pay back the entire loan plus interest. Home equity loans, on the other hand, have fixed repayment terms of 5-15 years. Cash-out refinances, on the other hand, typically have longer repayment terms of 15-30 years, which can result in lower monthly payments but higher total interest paid over the life of the loan.

Closing costs: HELOCs and home equity loans generally have lower closing costs than cash-out refinances because they are second mortgages rather than a complete refinance of the original mortgage.

Loan amount: HELOCs and home equity loans are typically smaller than cash-out refinances, which can allow for more flexibility in how you use the funds. However, the amount you can borrow with any of these options depends on factors such as your credit score, income, and home value.

Risks: HELOCs, home equity loans, and  Cash-out refinance can all be risky if you are unable to make the payments, as they use your home as collateral. If you default on the loan, you could lose your home. Cash-out refinances also come with risks, such as resetting the clock on your mortgage and potentially increasing your monthly payments.

How to Use A Home Equity Loan For A Home Remodel

Technically, you can use the lump sum of money that you get from a Home Equity Loan for anything. Home improvement projects are the most common purpose, though, with the US Census Bureau’s Housing Survey confirming that approximately 50% of Home Equity Loans are used in this way. 

Since a Home Equity Loan (or a 2nd mortgage for remodeling) lets you borrow a lump sum amount of money against the equity in your home, how much you can borrow depends on your home’s market value and mortgage balance. Though other factors such as your credit score, and income also impact how much you can borrow, you will usually be able to borrow between 80% and 90% of what you home is currently worth (minus your existing mortgage). The RenoFi Loan can take this one step further by giving you 90% of what your home will be worth after the renovation. 

How Much Can You Borrow with a HELOC?

Every lender has slightly different requirements for HELOC borrowing amounts, based on different factors.

However, the main factor that will determine your maximum line of credit is your Combined Loan-To-Value (CLTV) Ratio. Each lender will offer a different, maximum CLTV, although generally it will fall between 75% and 95%. A CLTV ratio is simply your mortgage, combined with your HELOC (second mortgage), divided by the value of your home.

For example, if your home is worth $400,000, you owe $300,000 on your mortgage, and you’d like a $50,000 line of credit, your CLTV ratio would be 87.5%

($300,000 + $50,000)/$400,000 = 0.875

CLTV isn’t the only factor that will determine your borrowing amount. Banks and credit unions will use things like credit score, income, expenses, and employment history to determine your “creditworthiness,” to see how much you can borrow and what your interest rate will be.

To fully understand how to use a Home Equity Loan for home improvement there are several factors you must consider:

1. Loan amount: Determine the total amount of money needed for your remodel and make sure the loan amount you are considering will cover it.
2. Interest rate: Consider the interest rate being offered by the lender, as a lower rate can save you money over the life of the loan.
3. Repayment terms: Understand the repayment terms, including the length of the loan and the monthly payments required, and ensure they fit within your budget.
4. Fees and closing costs: Be aware of any fees and closing costs associated with the loan, as they can add up quickly and affect the overall cost of the project.
5. Home equity: Calculate the amount of equity you have in your home and ensure you don’t borrow more than you can afford to repay.
6. Contractor payments: Plan to pay your contractor in stages as the work progresses, so you don’t pay for work that hasn’t been completed yet.
7. Project timeline: Consider the timeline of the project and ensure the loan terms fit within it, as well as any unforeseen delays or changes in the scope of the project.

The Pros & Cons of a Home Equity Loan for Renovations

Home Equity Loan Pros

• They’re almost always fixed-rate loans with set terms, payments, and schedules.
• Once you’re approved for a loan, you get the full amount in one lump sum.
• You pay off the loan in fixed payments over the life of the loan.
• Interest rates are locked in. If a loan term is 5-30 years, the interest rate won’t change over the years.
• The interest rates are typically lower than other credit products.
• Fixed monthly payments make it easy to budget.
• The interest may be tax-deductible.
• Can be a good way to convert the equity you’ve built up in your home into cash.
• You can pay off the loan early and refinance the loan at a lower rate (as long as you go through the credit process again).

Home Equity Loan Cons

• Tapping all the equity in your home in one swoop can work against you if property values in your area decline. If real estate values decrease, the market value of your house could decline, and you could end up owing more than your home is worth.
• The home could be sold to satisfy the remaining debt if the loan is not paid off or goes into default.
• If the loan goes into default, the bank may foreclose on or take back the home.
• If you relocate, and the home decreases in value, you could lose money on the sale of the home.

How to Use A Home Equity Line of Credit (HELOC) For Home Remodel

With a line of credit, you’re given access to a pool of cash that you can dip into and use as and when you need it as you renovate. And just like a credit card, as you pay it back, it’s available again to draw.You have a set length of time (usually 5 to 10 years) when you can draw on your line of credit. This is known as the draw period, and during this, payments that you make are only for the interest on the loan.

After the draw period ends, you’ll have a repayment period of a further 10 to 20 years, during which you make monthly payments that repay the loan amount and interest.

To fully understand how to use a Home Equity Line of Credit (HELOC) for home improvement there are several factors to consider:

1. Interest Rates: HELOCs typically have variable interest rates, which means that the interest rate you pay can fluctuate over time. Make sure to compare interest rates from different lenders and understand how changes in the interest rate can impact your monthly payments.
2. Fees: HELOCs may come with fees such as application fees, annual fees, or early termination fees. Make sure to understand all fees associated with the loan.
3. Loan Amount: HELOCs allow you to borrow against the equity you have in your home, but the amount you can borrow will depend on the value of your home and how much equity you have. Make sure to calculate how much you can borrow before starting your renovation project.
4. Repayment Terms: HELOCs typically have a draw period during which you can borrow money, followed by a repayment period during which you must pay back what you borrowed. Make sure to understand the repayment terms, including the length of the draw period and the repayment period, as well as any minimum monthly payments.
5. Renovation Budget: Before using a HELOC for a renovation project, make sure to create a budget that includes all the costs associated with the renovation, including materials, labor, and any additional fees. This will help ensure that you borrow the right amount and avoid overextending yourself financially.
6. Future Plans: Consider how long you plan to stay in your home and whether the renovation will add value to your home. If you plan to sell your home in the near future, make sure the renovation will add enough value to justify the cost of borrowing. If you plan to stay in your home for a long time, the renovation may be worth the investment.

The Pros & Cons of a HELOC for Renovations

HELOC Pros

• While a Home Equity Loan gives the borrower all the money in a lump sum, a HELOC allows the borrower to tap into the line only as needed.
• The line of credit remains open until its term ends.
• You know the maximum amount you can potentially borrow, which is the amount of the credit limit. You get the flexibility to borrow as much or as little of that money as you need for your project. You pay interest only on the amount you draw (rather than the total in your credit line).
• Repayment terms are flexible, so you can pay it off or make minimum monthly payments.
• Interest may be tax-deductible if used for a major home improvement (consult your tax advisor).

HELOC Cons

• A HELOC is secured by an asset (your house). If you stop making the payments on the HELOC, you could lose your home.
• A HELOC has a variable interest rate. The minimum payment could increase as interest rates rise. This can make it difficult to determine the overall cost of a HELOC going into it.
• During the HELOC’s draw period, you still have to make payments, which are typically interest-only. The payments tend to be small during the draw period, but they do become substantially higher in the repayment period since the principal amount borrowed is now included in the payment schedule along with interest. The transition from interest-only payments to principal-and-interest payments can be quite drastic, so budget accordingly.
• A HELOC is revocable, like a credit card. If your financial situation worsens or your home’s market value declines, your lender could decide to lower your credit line or close it. In other words, your ability to access the money isn’t always guaranteed.
• Without discipline, you could overspend.

Expert Opinions on When to Use a HELOC For Home Improvement

HELOCs (Home Equity Lines of Credit) are best for homeowners who need flexibility in accessing funds for their home improvement projects. If you need access to funds quickly, a HELOC may be a better option. 

People sometimes prefer HELOCs because they are more flexible, if you’re not sure how much money you’ll end up needing, but want the freedom to tap into your line of credit at any time. HELOCs allow borrowers to draw funds as needed during a specified draw period, which typically lasts 10 years and only pay interest on the amount borrowed. Those who have home improvement projects with fluctuating costs or who may need access to funds over an extended period of time may benefit most from using a HELOC. 

There will be a set time to begin repayments later down the line, if you know you won’t be able to begin paying back the fund immediately a HELOC is potentially a good option for you.

Additionally, borrowers who have good credit scores and equity in their homes may benefit from using a HELOC because they may be able to secure a lower interest rate compared to other forms of credit, such as credit cards or personal loans.

Expert Opinions on When to Use a Home Equity Loan for Home Improvement

Home Equity Loans are best for homeowners who have a specific home improvement project with a set cost and timeline and need a lump sum of money upfront. Home Equity Loans offer a fixed interest rate and fixed monthly payments over a specified term, typically ranging from 5 to 30 years. 

Home Equity Loans are a good idea for home improvement for those who want a predictable and stable repayment plan, but note that you are required to pay Home Equity Loans almost immediately. A Home Equity Loan is good if you know exactly how much you need to borrow and how the money will be used. Once approved, you’re guaranteed that amount, and you receive it in full. Also, a good idea, if you need a fixed amount of money and do not want to continuously draw from a credit line, a Home Equity Loan may be a better choice.

Homeowners who have a good credit score, equity in their home, and a reliable income may benefit most from using a Home Equity Loan over a HELOC. Home Equity Loans typically offer lower interest rates than unsecured loans, such as personal loans or credit cards, due to the collateral of the home.

Additionally, those who prefer the stability of fixed monthly payments and a set repayment schedule may find a Home Equity Loan to be a better fit for their financial needs. With a Home Equity Loan, borrowers know exactly how much they need to pay each month and when the loan will be fully repaid.

Renovation Loan Expert Tip: However, it’s important to note that with a Home Equity Loan, borrowers are required to take out the full amount of the loan at once, and they will start making payments on the full amount immediately, even if they haven’t used all of the funds for their home improvement project. This lack of flexibility can be a disadvantage for those who have a project with fluctuating costs or need ongoing access to funds.

If you’d like to explore your options, contact a RenoFi Advisor to learn more.

Tips for Choosing the Best Option for You

HELOCs and home equity loans are both considered “second mortgages,” as they are in second position compared to your first mortgage, and you’re borrowing from your home as collateral.

However, HELOCs function as a “line of credit,” like credit cards, where during the draw period, you can draw smaller amounts of money only when you need it. With home equity loans, you’re required to borrow the entire loan amount in a lump sum and begin paying it off almost immediately.

People sometimes prefer HELOCs because they are more flexible if you’re not sure how much money you’ll end up needing, but want the freedom to tap into your line of credit at any time.

Home equity loans are normally fixed-rate, and HELOCs are generally variable-rate, which is another difference between the two options.

Ask yourself about the purpose of the loan.

A home equity loan is good if you know exactly how much you need to borrow and how the money will be used. Once approved, you’re guaranteed that amount, and you receive it in full.

A HELOC is good if you’re not sure how you’ll need to borrow it or when exactly you’ll need it. It gives you access to cash for a set period of time.

If you aren’t comfortable with the HELOC’s variable interest rate, you may prefer a home equity loan for the stability and predictability of fixed payments.

Make sure you do not borrow more than you can afford to pay back.

Try the RenoFi Loan Calculator to see how much you can borrow.

Or, if you’d like to explore your options, contact a RenoFi Advisor to learn more.

Home Equity Loan & HELOC FAQs

Home equity loans and lines of credit can be confusing, we get it.

To help you out, here are answers to some of the most commonly asked questions about these two renovation financing options.