HELOC vs. Mortgage: Differences, Costs & Benefits

A Home Equity Line of Credit (HELOC) is a form of revolving credit secured by the borrower’s home equity. With a HELOC, the lender agrees to lend the borrower a maximum amount based on the home’s appraised value minus any existing mortgages. It works similarly to a credit card, allowing the borrower to withdraw funds as needed up to the credit limit. 

HELOCs differ from home equity loans in that they are revolving lines of credit rather than fixed amount loans. The borrower can withdraw funds multiple times over the draw period, typically 10 years. During this period, the borrower only pays interest on the amount withdrawn. After the draw period ends, regular principal and interest payments are due to pay off the balance over a specified repayment period, usually 10-20 years.

How Does a HELOC Work?

A lender first appraises the home to determine its market value. They then calculate the amount of equity available, which is the market value minus any mortgage balances owed. The HELOC credit limit is set at a percentage of available equity, commonly 80%.

For example:

• Home market value: $400,000
• Mortgage balance: $200,000
• Available equity: $400,000 – $200,000 = $200,000
• 80% of available equity: $200,000 x 0.8 = $160,000
• Maximum HELOC credit limit: $160,000

During the draw period, the borrower can access funds up to the credit limit. They will pay interest monthly only on the amount withdrawn. After the draw period ends, repayment begins with principal and interest payments due each month until the balance is paid off. 

HELOCs often have variable interest rates tied to a benchmark like the prime rate. This means the rate can fluctuate over time. The minimum monthly payment is usually interest-only or 1-2% of the balance.

Is a HELOC Considered a Mortgage?

While HELOCs share some features of mortgages, they are legally distinct financial products. HELOCs are not considered mortgages under financial regulations. The key differences between HELOCs and mortgages relate to interest rates, repayment terms, use of funds, and application process.

Differences Between a HELOC and a Mortgage

1. Interest Rates

Most HELOCs have variable interest rates that adjust periodically based on market conditions. Mortgages typically have fixed interest rates that remain constant over the full loan term. Adjustable-rate mortgages (ARMs) also exist but less commonly than fixed-rate mortgages.

2. Repayment Terms

HELOCs have a multi-phase structure with a draw period where only interest is due, followed by full principal and interest payments. Mortgages involve regular amortized principal and interest payments over the full loan term. There is no interest-only period with standard mortgages.

3. Use of Funds

HELOCs can be used for almost any purpose such as home improvements, debt consolidation, or major purchases. Mortgages must be used to purchase or refinance a home specifically.

4. Application Process

HELOCs involve a simpler application process than mortgages, often based on a borrower’s credit score and home equity alone. Mortgages require extensive financial documentation, appraisals, and strict debt-to-income calculations. 

5. Risk Factors

HELOCs pose some unique risks, including variable interest rates and tempting access to a large credit line. Mortgages have fixed payments and terms, providing structure and predictability. However, foreclosure is possible with both if payments cannot be made.

Advantages of Using a HELOC Over a Traditional Mortgage

In certain situations, a HELOC can provide more flexibility and cost savings compared to a traditional mortgage:

• Lower interest rates – HELOC rates are often lower than mortgage rates, saving on interest expenses. Rates averaged 3.67% for HELOCs compared to over 6% for 30-year mortgages in early 2023 (Source: Bankrate.com).
• Interest savings during draw period – Paying interest-only on the amount withdrawn during the HELOC draw period postpones higher principal and interest payments.
• Access funds as needed – The revolving line of credit structure allows borrowing only what is needed. With a lump sum mortgage, the full amount must be borrowed upfront.
• Avoid multiple loan applications – HELOC funds can be drawn as needed instead of taking out multiple loans.
• Shorter repayment term – HELOCs may be repaid in 10-20 years. Mortgages run for 30 years or longer.

Disadvantages of Using a HELOC Over a Traditional Mortgage

However, there are also some potential downsides of using a HELOC instead of a standard mortgage:

• Variable interest rates – HELOC rates fluctuate so monthly payments are less predictable than fixed mortgage payments.
• Discipline required – It can be tempting to over-borrow with a large available credit line. Strict discipline is required to only withdraw needed amounts.
• Closing costs – Although lower than a mortgage, HELOCs still incur closing costs including appraisal and origination fees.
• Prepayment penalties – Some HELOC lenders charge prepayment penalties if the balance is paid off early. Mortgages rarely have prepayment penalties.
• Lower balance reduces equity – As the lender has a lien on the property, a HELOC balance reduces the borrower’s net home equity until repaid.

When Should You Consider Getting a HELOC?

There are a few situations where a HELOC can be advantageous, including:

• Planning significant home renovations or repairs
• Consolidating higher interest credit card balances 
• Paying for a major purchase like college tuition
• Building an emergency fund as a line of credit safety net
• Serving as a bridge loan when purchasing a new home before selling the old home

HELOCs allow borrowing funds on an as-needed basis at competitive rates for qualified borrowers. They provide ready access to home equity without needing to refinance or get a second mortgage.

When Should You Avoid Getting a HELOC?

On the other hand, HELOCs may not be the right option in some cases:

• If you have less than 15-20% equity in your home
• If you have poor credit and may not qualify for a low rate
• If you have trouble managing debt or credit wisely
• If your income is unstable and you may struggle to make payments
• If you hope to pay off your mortgage before retirement

Those will little home equity, credit challenges, or inconsistent finances may be better served by alternative financing options beyond a HELOC.

Understanding the Risks Associated with HELOCs

While HELOCs offer homeowner benefits, they also come with some unique risks to consider:

• Payment shock – If rates rise significantly, monthly payments could increase markedly based on the variable interest rate.
• Overborrowing – Accessing too much credit can over-leverage the borrower and make repayment difficult. Around 20% of HELOC borrowers max out their available credit. (Source: NerdWallet)
• Credit freezing – Lenders can freeze the available credit line if the value of the home declines sharply. This can happen in recessions.
• Foreclosure – Failure to repay the HELOC balance can result in foreclosure if arrangements cannot be worked out with the lender.
• Credit score impact – High balances relative to credit limits can lower credit scores. Closed accounts also lower average account age impacting scores.

Carefully evaluating repayment ability, avoiding over-borrowing, maintaining creditworthiness, and keeping loan-to-value ratios low can mitigate key HELOC risks. Seeking professional advice is recommended.

How to Apply for a HELOC

If a HELOC aligns with your financial needs and profile, the application process involves these key steps:

• Check your credit score and report for any issues to address first
• Estimate your property’s current market value to determine available equity
• Shop and compare HELOC rates and terms from multiple lenders 
• Select a lender and complete their HELOC application and documentation
• Allow time for the lender to appraise the property and process the application
• If approved, proceed to close on the HELOC and make funds accessible per the agreement

Closing often takes between 2 to 6 weeks from application to funding. Closing costs range from a few hundred to a few thousand dollars. Minimum credit scores for approval are typically 680 or higher.

Alternatives to Using A HELOC

Some alternatives to consider besides a HELOC include:

• Cash-out mortgage refinance – Tap equity while refinancing into a new mortgage
• Traditional fixed mortgage – Borrow needed funds upfront within one standard mortgage
• FHA 203(k) mortgage – Finance major home renovations through an FHA-insured mortgage 
• Home equity loan – Borrow a fixed amount all at once rather than a line of credit
• Personal loans – Unsecured loans based on income and credit scores alone
• Retirement account loans – Borrow against balances from 401(k) or IRA accounts 

Each option has pros and cons to weigh based on your specific financial situation and priorities. Consulting a financial advisor can provide objective guidance.

HELOCs provide flexible access to home equity but also come with unique risks and considerations around cost, qualifications, and repayment. Given the complexity, homeowners are advised to thoroughly research HELOCs and alternative financing options when needs arise.