HELOC vs home equity loan – what's the difference?

When Canadian homeowners are facing major expenses, home equity loans or home equity lines of credit (HELOCs) can serve as viable options for extra funds. While these financing options offer flexibility, it’s crucial to understand their differences before taking any of them on.

What is a home equity loan?

A home equity loan allows a homeowner to borrow a lump sum of money with the equity built up in their home as collateral. This is usually referred to as a second mortgage and can be used to finance larger expenses such as home improvements, debt consolidation, education expenses or emergencies. A home equity loan allows you to borrow up to 80 per cent of your home’s equity at a higher rate than normal prime mortgages, but generally at a lower interest rate than other loans such as credit card debt and payday loans. It also is repaid over a set number of years, which makes it a stable and predictable option. Often times, it is also interest only, so monthly payments are lower, too.

Similar to the process of getting a mortgage, homeowners need to apply for the loan and get approval from lenders. To qualify, homeowners typically need to have paid off at least 15 to 20 per cent of your home’s value and maintain a credit score of 700 or above. It’s also recommended to keep your debt below 43 per cent of your total monthly income.

Pros

• Lower interest rates than personal loans or credit cards
• Flexibility in how the funds can be used
• Fixed monthly payment makes budgeting easier

Cons

• Though lower than other loans, interest rates are much higher than normal prime mortgages, and often come with a one- to three-per-cent fee, too
• Risk of home loss if you fail to make payments
• Fixed interest rate which can be a disadvantage in a low interest rate environment
• Funds are limited and homeowners cannot take out any more in case of emergency

What is a Home Equity Line of Credit (HELOC)?

A Home Equity Line of Credit (HELOC) can be a flexible alternative for homeowners who need access to funds. Similar to a credit card, a HELOC allows you to withdraw money up to a certain limit, depending on how much you need, and you’re required to pay interest on only the amount borrowed. However, it’s important to note that the interest rate is variable and can change based on market conditions.

The initial draw period usually lasts about 10 years and allows homeowners to utilize the available funds at their discretion. After that, the loan enters the amortization phase, which can span approximately 20 years, during which you make regular monthly payments.

Applying for a HELOC follows a similar process to a home equity loan. Lenders evaluate the market value of your home, conduct an assessment of your financial history to determine if you’re eligible and consider factors such as your home equity, debt-to-income ratio and credit history.

Pros

• Flexible credit usage
• Potential for lower interest rates if your credit improves or if market interest rates go down
• Credit line available for emergencies

Cons

• Payment fluctuations can make budgeting difficult
• Potential for higher interest rates if your credit declines or market interest rates go up
• Risk of home loss if you default
• Flexibility of credit limit increases likelihood of overspending

As we move into a higher interest rate environment as we have seen recently, these options should be looked at as an “as needed” loan decision. They can be expensive and large financial decisions to make. So, before taking on any additional loans, it’s important to read the fine print and understand how they can improve and/or impact your financial health and future.