HELOC Vs. Mortgage: A Guide

When researching home financing options, you might encounter the term “HELOC,” the commonly used abbreviation for a home equity line of credit. But what is a HELOC? And is there a difference between HELOCs and mortgages?

There is. A mortgage is any type of loan you take to finance the purchase or refinancing of a home. A HELOC, though, is a type of second mortgage, one that you can apply for after you’ve built enough equity in your home.

What are the key differences between a home equity line of credit and a mortgage? Read though this guide to find out.

Mortgage Vs. HELOC: Explained  

When buying or owning a home, it’s important to understand the difference between a primary mortgage and a home equity line of credit.

What Is A Mortgage?

A mortgage is a type of loan you apply for to finance the purchase of a home.

You can choose from several types of mortgages, including those with fixed interest rates and those with adjustable interest rates that rise or fall throughout the life of your loan.

Some of the more common types of mortgages are 30-year and 15-year fixed-rate loans. You’ll have 30 years or 15 years to pay back these mortgages, which you’ll do by making monthly payments with interest. The interest rates with these mortgages never change.

You can also refinance your existing mortgage loan, swapping it out for a new one. Homeowners usually do this when they want to lower their interest rate and monthly payment.

What Is A Home Equity Line Of Credit (HELOC)?

A home equity line of credit (HELOC) is a type of second mortgage, a mortgage that you take out in addition to your existing primary mortgage.

Homeowners take out second mortgages for a variety of reasons, whether to fund a home-renovation project, pay off their high-interest-rate credit card debt or pay for a child’s college education.

To apply for any type of second mortgage, including a HELOC, you’ll first need equity in your home. Equity is the difference between what you owe on your mortgage and what your home is worth. Say your home is worth $400,000 and you owe $250,000 on your mortgage. You have $150,000 in equity.

Lenders then let you borrow a portion of that equity, often up to 80%. If you have $150,000 in equity, then, you might be able to take out a home equity line of credit for as much as $120,000. You can borrow from that line of credit to pay for whatever you like.

A HELOC acts a bit like a credit card. You only pay back what you borrow. Say you have that $120,000 line of credit. If you borrow $60,000 to pay for a kitchen remodel and $20,000 to pay off your credit card debt, you’ve borrowed a total of $80,000. If that’s all you borrow, that’s all you pay back.

While you can use your HELOC to pay for anything, you’ll receive a tax break if you use your funds to pay for renovations or improvements that boost the value of your home. If you do this, you can deduct the interest that you pay on your HELOC draws on your income taxes.

Rocket Mortgage does not offer HELOCs.

Key Differences: Home Equity Line Of Credit Vs. Mortgage Loan

What are the biggest differences between a home equity line of credit and a primary mortgage loan? There are many.

How They’re Used

The biggest difference is how a mortgage and HELOC are used.

You’ll use a primary mortgage to finance the purchase of your home. It’s a way for people to buy homes when they don’t have enough money to make an all-cash offer on a property.

Homeowners use HELOCs to access money through the equity in their homes. Owners can use HELOCs to fund anything, including home improvements and repairs, their children’s college tuitions, a child’s wedding or a cruise around the world. They can also use a HELOC to pay off credit card debt. There are no limits to what you can use the funds from a HELOC for.

Interest Rates

The interest rates with a primary mortgage are usually lower than those that come with a HELOC.

With a mortgage, you can also choose from a fixed-rate loan or a loan that comes with adjustable rates. HELOCs usually come with variable, or adjustable, interest rates.

It’s important to understand the difference between fixed rates versus adjustable rates. With a fixed-rate loan, your interest rate never changes, remaining the same on the first day of your loan as it is on your last.

Adjustable rates, though, change during the life of your loan. An adjustable-rate loan’s interest rate typically remains fixed for 5 – 7 years. After that time, its rate adjusts on a set schedule, usually rising or falling once a year, based on whatever economic index it is tied to. When your interest rate rises, your monthly payment will rise, too. It’s important when taking out an adjustable-rate mortgage to make sure that you can afford this higher monthly payment.

Acquisition And Repayment Of Funds 

You can apply for a mortgage whenever you want to buy a home or refinance an existing mortgage loan. You can only apply for a HELOC after you’ve already purchased a home and you’ve built enough equity.

To apply for both types of loans, you’ll need to fill out a mortgage application with your lender. Many lenders will let you do this online.

Repayment works differently for a mortgage and HELOC, too. With a primary mortgage, you repay what you’ve borrowed with regular monthly payments, with interest. You’ll often pay extra, too, to cover the costs of property taxes and homeowners’ insurance.

HELOCs come in two phases, the draw period and the repayment period. During the draw period, you can borrow against your line of credit. During this period, which usually lasts up to 10 years, your monthly payments only cover the interest on what you borrow. This means that your payments are smaller.

Once the draw period ends, your HELOC enters its repayment period, which can last up to 20 years. During this time, you no longer can borrow money from your line of credit. You’ll also pay off both interest and your principal balance with your monthly payments, meaning that your payments will rise. Your lender will determine a monthly payment amount that lets you pay off the money that you borrowed in full by the time your repayment term ends.

Qualifying For A HELOC Vs. Mortgage

Lenders will check your three-digit FICO^® credit score when you apply for both a HELOC and mortgage. The minimum score you need will vary by lender. To qualify for an FHA loan, for instance, you’ll need a FICO^® Score of at least 580 for a loan that requires a minimum down payment of 3.5% and a minimum of 500 for one that requires a down payment of at least 10% of your home’s purchase price.

For conventional loans, ones not insured by any government agency, you’ll typically need a FICO^® Score of at least 620, though this will vary by lender.

Lenders will also check your debt-to-income ratio for both HELOCs and mortgages. Though it varies by lender, most want your total monthly recurring debt payments, including your new mortgage payment, to equal no more than 43% of your gross monthly income.

To qualify for a HELOC, you’ll also need equity in your home. If you don’t have enough equity, you won’t be able to borrow enough to make a HELOC worthwhile. You don’t need equity to qualify for a purchase mortgage. But when you provide a down payment, you’ll generate instant equity in your new home. Your required down payment will vary, but you might qualify for a conventional loan that requires a down payment as low as 3% of your home’s final purchase price.

Is A HELOC Or A Mortgage Right For You?

Taking on either a HELOC or mortgage is a big financial decision. How do you know if it’s the right one for you?

Start by creating a household budget listing your expenses and revenues. This will tell you how much money you can afford to spend each month on either a mortgage or HELOC.

Look, too, at your personal financial habits. Do you pay your bills on time each month or is making your payments a struggle? Do you only pay your minimum required credit card payments or do you never carry a balance on your cards from month to month? If you already pay your bills on time and you don’t carry credit card debt? You might be ready to take on the financial responsibility of a mortgage.

When considering a HELOC, make sure that you can afford the new payments that will come whenever you borrow from it. Make sure, too, that you can afford the higher monthly payments once your HELOC enters its repayment period.

Look at what you want to spend your money on, too. HELOCs are attractive because they usually come with lower interest rates than what you’d get with a personal loan or by using credit cards to cover big expenses. But decide if the project or expense that you want to fund is necessary. If you fail to make your HELOC payments, your lender could foreclose on your home. You’ll need to determine if the money you receive from a HELOC is worth that risk.

Additional Types Of Mortgage Loans

If you are looking for alternatives to a HELOC, you have several choices:

• Home equity loan: One of the more popular alternatives to HELOCs are home equity loans. Like with HELOCs, you’ll need equity to take out a home equity loan. The amount of equity you have determines how much you can borrow. Unlike HELOCs, you receive your funds in a single lump sum that you can spend however you’d like. You then repay this money with regular monthly payments, with interest. Home equity loans typically come with fixed interest rates. Rocket Mortgage® offers a Home Equity Loan for use with primary or secondary homes.  
• Cash-out refinance: A cash-out refinances is another way for homeowners to access cash, and also one that requires equity. In this type of refinance, you refinance your existing mortgage loan for more than what you owe on it and take the extra funds as a single payment. Say you owe $200,000 on your mortgage. You can refinance your existing loan to a new mortgage of $270,000, taking the extra $70,000 as a single payment that you can spend however you’d like. You then repay the total amount that you borrowed with regular monthly payments with interest. 
• Reverse mortgage: A reverse mortgage is a loan that allows homeowners 62 or older to borrow against a portion of the equity that they've built in their home. Unlike with a traditional mortgage, though, you won't make payments to your lender. Instead, your lender will pay you each month. Seniors might take out a reverse mortgage to add an income stream in their retirement years. A reverse mortgage doesn't have to be paid back until you die or you sell the home. If you die, your heirs will most likely have to sell your home and use the proceeds from the sale to repay your reverse mortgage.

The Bottom Line

Both a standard mortgage and HELOC are useful financial tools, though you’ll use these tools to reach different goals. If you are ready to apply for a mortgage or explore other financing options, such as a home equity loan, start the approval process with Rocket Mortgage today.