Home Equity Loan vs HELOC: Key Differences

How each product works

A home equity loan is closed-end credit. The CFPB says: “You receive the money from a home equity loan as a lump sum.” It adds that this loan “usually has a fixed interest rate–one that will not change.”

A HELOC is open-end credit. The CFPB calls it a line “that allows you to borrow repeatedly against your home equity.” The borrower draws money as needed, up to a credit limit, during a draw period. When that period ends, borrowing stops and the repayment period begins.

Draw and repayment periods on a HELOC

The CFPB notes that “Monthly payments are often significantly higher once you enter repayment.” In some plans, a borrower “may have to pay back the whole amount you borrowed as soon as the repayment period begins.” That lump payment is called a balloon payment.

Regulation Z requires the lender’s disclosures to state “The length of the draw period and any repayment period.” The disclosures must also include an example “based on a $10,000 outstanding balance.” That example shows the minimum payment, any balloon payment and how long repayment would take. Lenders must give these disclosures, plus a brochure, “at the time an application is provided to the consumer.”

Variable rates and what the lender can change

The CFPB states that “HELOCs usually have a variable interest rate, so your payments may change from month to month.” Some plans let the borrower convert part or all of the balance to a fixed rate.

Regulation Z sets three limits on variable HELOC rates:

• Index rules. A lender may change the rate only if the change “is based on an index that is not under the creditor’s control.” That index must also be “available to the general public.”
• Historical example. The disclosures must show how rates and payments would have moved over “the most recent 15 years of index values.”
• Maximum rate. The lender must state “the maximum annual percentage rate that may be imposed under each payment option.”

A lender can freeze or reduce a HELOC in specific cases. One case is when the home’s value “declines significantly below the dwelling’s appraised value for purposes of the plan.” Another is a “material change in the consumer’s financial circumstances.” A lender can terminate a HELOC and demand the full balance only in limited cases. These are fraud or material misrepresentation, failure to meet repayment terms, and action or inaction that harms the lender’s security.

For rate basics, see mortgage rates explained.

Fees, cancellation rights and taxes

Fees before opening. Under Regulation Z, no one may charge a nonrefundable HELOC application fee “until three business days after the consumer receives the disclosures and brochure.” If a disclosed term changes before the plan opens and the consumer decides not to open it, the lender “shall refund all fees.” The CFPB also warns that home equity loans “may have upfront fees and costs.” See closing costs explained and home appraisal cost.

Right to cancel. Both products allow cancellation when the lien is on the borrower’s principal dwelling. The consumer may rescind “until midnight of the third business day” after the triggering event, the rescission notice or the required disclosures, whichever comes last. If the required notice or disclosures are never delivered, the right expires after 3 years. For home equity loans, this right does not apply to “A residential mortgage transaction”, which is the loan used to buy the home.

Interest deduction. The IRS states that interest on home equity loans and lines of credit is deductible “only if the borrowed funds are used to buy, build, or substantially improve the taxpayer’s home that secures the loan.”

Risks to weigh

• Foreclosure. The CFPB warns: “If you cannot pay back the HEL, the lender could foreclose on your home.” For a HELOC, it says: “If you fall behind or can’t repay the loan on schedule, you could lose your home.”
• Payment shock. HELOC payments can rise with a variable rate and when repayment begins.
• Debt consolidation. Before using a home equity loan to pay off debts, the CFPB suggests talking to a credit counselor about options “that do not potentially put your home at the risk of a forced sale.”

A cash-out refinance is another way to tap equity. See refinancing. Lenders review income against debts; see debt-to-income ratio.