Unfortunately, with the fixed-rate loan, you will be on the hook for closing costs that are similar to what you paid on your mortgage. They may total up to 6% of your loan and will include things such as attorney fees, your home appraisal, a title search, and document preparation.
You may also pay a higher interest rate than with a HELOC since it’s locked in. Your payments will be higher because they’ll include both the principal of the loan and interest. And you won’t be able to access more money if you need it — your lump-sum payout is all you get, and you’ll need to allocate it wisely.
A HELOC functions much like a credit card. You have a borrowing limit and a specified “draw” period, typically 10 years, during which you can generally borrow whatever you want whenever you need it, making interest-only payments along the way. The draw period is followed by a repayment period, typically 15 years. During this period you can no longer borrow from your HELOC and must repay both principal and interest.
The flexibility of a credit line is the big pro with a HELOC. You can borrow money, pay it back, and borrow it again. You may also nab a pretty low introductory interest rate, and you only pay interest on what you borrow during your draw period, not your total line of credit. Though there are fees, they usually aren’t as steep as those associated with fixed-rate home equity loans. Interest is tax-deductible, too.
Of course, because HELOCs have variable interest rates, it’s harder to budget for payments. If you open a HELOC and interest rates rise significantly, you could be stuck paying more than you may have bargained for (there is typically a cap on your rate, but it might be fairly high).
Your lender also reserves the right to freeze your HELOC if your home’s value drops precipitously or they feel you’ve lost your ability to repay. And if you only paid interest during the draw period, you’ll be shelling out a lot more during the HELOC’s repayment period. The much larger payments can cause huge financial hardship if you don’t plan for them.
Should I choose a home equity loan or a HELOC?
It’s hard to say which one will be best for you, but here are some general guidelines:
Consider a home equity loan if:
You need money for one large project or event. You will get the money you need from the fixed-rate loan in one lump sum.
You don’t have the discipline to pay more than you have to — or resist using more money than you truly need — even when it’s best in the long run. A fixed-rate loan will give you only one-time access to cash, and your payment will be fixed. A HELOC, on the other hand, may allow tempting interest-only payments that could hurt you in the long run.
You’re afraid interest rates will rise significantly. A fixed-rate loan will protect you from this risk.
Consider a HELOC if:
You need access to cash for ongoing projects or expenses. You can take the money you need from your HELOC as you need it.
You’ll only need small amounts you can pay back swiftly. You’ll probably pay less in interest with a HELOC.
Interest rates are low and you’re willing to bet they’ll stay that way. A HELOC better lets you take advantage of low rates. But if you think rates will rise, use a home equity loan to lock in the low rate.
You need a safety net, or are in the process of building an emergency fund. A HELOC is an inexpensive way to have a built-in safety net. You may never never need to touch it, but it’s nice to know it’s there if you don’t have other options.
Final Thoughts on Using Home Equity Loans
If you tap your home equity for a clear purpose and are confident you can repay the money without difficulty, a home equity loan might be a good choice for you. If you want money fast for a frivolous reason or can’t comfortably afford another payment, think twice.
Just like your primary mortgage, a home equity loan is serious business. For responsible borrowers, it can be a great tool. But if you don’t plan ahead, your home could be on the line.
If that’s a risk you can comfortably take, start your search for the best home equity loan rates with a comparison site like Lending Tree.