HELOC vs. Personal Loan or Credit Card – Which Should You Choose or Avoid?

Navigating the world of finance can be daunting, especially when choosing between borrowing options. As a homeowner, you have an array of choices at your fingertips. Today, we'll delve into two popular options: Home Equity Line of Credit (HELOC) and personal loans. Each has its unique advantages and disadvantages, and the best choice depends on your specific situation. Let's break down the pros, cons, and best uses for each option to help you make an informed decision.

HELOC vs. Personal Loan

Before we delve into the pros and cons of each, let's define these two borrowing options. A HELOC is a loan where the lender agrees to lend a maximum amount within an agreed period. The borrower's equity in their house acts as the collateral. A personal loan is a loan supported solely by the borrower's creditworthiness and does not require collateral.

Pros and Cons of a HELOC

On the plus side, a HELOC typically offers lower interest rates than personal loans, making it attractive if you are budget-conscious. Furthermore, the interest you pay on a HELOC is often tax-deductible if you use the borrowed money to buy, build, or substantially improve the home securing the loan. This aspect can further decrease the effective cost of borrowing.

However, a HELOC also comes with certain drawbacks. One of the biggest concerns is that your home serves as collateral, which means if you default on the loan, the lender could potentially take possession of your home. Additionally, obtaining a HELOC requires that you have available equity in your home. And, although generally lower than the costs for a full refinance, HELOCs may have closing costs, which could add to your expenses.

Pros and Cons of a Personal Loan

A personal loan is unsecured, meaning it doesn't require you to put up any collateral, like your house or car. This reduces your risk because if you can't repay the loan, the lender can't directly seize your assets. Additionally, personal loans usually involve a fixed interest rate, giving you the assurance of steady payment amounts throughout the life of the loan.

On the downside, a personal loan typically has higher interest rates than a HELOC or mortgage loans due to its unsecured nature. Your eligibility and the interest rate you receive are heavily dependent on your creditworthiness. If you have a low credit score, you may not qualify for a personal loan, or you might get stuck with a high interest rate.

When is a HELOC a better option?

A HELOC might be a superior choice if you have significant home equity or if you need access to a larger amount of money over time. This flexible line of credit allows you to borrow only what you need, when you need it. If you have high-interest debt, such as credit card debt, a HELOC can also be an effective tool for debt consolidation.

When is a personal loan a better option?

A personal loan is usually better for smaller, short-term borrowing needs because it doesn't require equity in your home and funds are typically disbursed quickly. If you need funds for a one-time expense and desire fixed payments, a personal loan could be the right choice.

HELOC vs. Refinance

Now, let's compare a HELOC to another option available to homeowners: refinancing. Refinancing your home loan means replacing your current mortgage with a new one, which could involve a cash-out refinance or a home equity loan refinance. How do they stack up against a HELOC?

Types of refinancing options

In a cash-out refinance, your existing mortgage is replaced with a new home loan for more than you owe on your house. The difference between the old and new mortgage is given to you in cash, which you can use for a variety of financial needs, such as home improvements, education expenses, or debt consolidation.

A home equity loan refinance functions similarly to a HELOC, in that you borrow against the equity in your home. However, with this option, you receive the funds in a lump sum and repay the loan at a fixed interest rate, resulting in predictable monthly payments.

Pros and Cons of a Cash-out Refinance

A cash-out refinance can be beneficial if you are able to secure a lower interest rate than your current mortgage rate, effectively reducing your monthly payments. This refinancing option may offer lower interest rates than a HELOC or personal loan, and the interest paid may be tax-deductible.

However, there are also downsides to a cash-out refinance. Closing costs for this type of refinancing can be higher since you are taking out a completely new mortgage. You are also increasing your original mortgage amount, which could potentially extend the life of your loan and the time it takes to build equity.

Pros and Cons of a Home Equity Loan Refinance

With a home equity loan refinance, the main benefit is the fixed interest rate. This allows for predictability in your budgeting, as your monthly payment amount will remain constant over the life of the loan. It can be a good option if you need a large sum of money for a specific purpose and want the security of fixed monthly payments.

The downside of a home equity loan refinance is that it requires enough equity in your home, much like a HELOC. Moreover, just as with a HELOC, your home serves as collateral for the loan. This means that if you default on the loan, your home could be at risk.

When is a HELOC a better option?

A HELOC may be more advantageous if you need ongoing access to funds or prefer lower up-front costs. Unlike refinancing options, a HELOC provides a revolving line of credit that allows you to borrow only what you need, potentially saving you on interest costs over time.

Another time where a HELOC is a better option than a refinance, is when the current interest rates are higher than your current home mortgage. It might not be worth it to refinance your entire outstanding home loan to an interest that is 1 or more points higher just to grab access to funds.

When is refinancing a better option?

Refinancing can be a superior option if you can secure a lower interest rate than your current mortgage, need a lump sum of money for a specific purpose, or prefer the certainty of a fixed interest rate. Both a cash-out refinance and a home equity loan refinance offer these benefits.

HELOC vs. Credit Cards

When it comes to choosing between a HELOC and a credit card, both can offer a flexible form of borrowing, but they serve different needs and situations. Let's unpack the pros and cons of each, to help you understand which one might be better for you.

Pros and Cons of Credit Cards

Credit cards offer the convenience of purchasing now and paying later, often with rewards like cash back or travel points. With a good credit score, you might qualify for a card with a low introductory interest rate, providing a cheap short-term borrowing option. Also, because credit cards are unsecured, you don't have to risk your home or other assets to use them.

However, credit cards often come with higher interest rates compared to other forms of borrowing, especially after any introductory rates expire. Carrying a high balance can harm your credit score, and failing to make payments can lead to late fees and increased interest rates.

When is a HELOC a better option?

A HELOC may be a more beneficial choice if you need ongoing access to funds or prefer lower up-front costs. A HELOC provides a revolving line of credit that allows you to borrow only what you need, potentially saving you on interest costs over time. However, as mentioned previously, your home serves as collateral for the loan, meaning that you could risk your home if you fail to repay.

When is using a credit card a better option?

A credit card can be the right choice for short-term, smaller, or emergency expenses, as they offer instant access to credit. It may be beneficial if you can pay off your balance quickly or take advantage of a low introductory rate. If you're disciplined with repayments and use a card with rewards, you can benefit from perks while building credit history. However, beware of the higher interest rates associated with carrying a balance long term.

A personal decision

Choosing the best borrowing option depends on your financial situation, the amount you need to borrow, your ability to repay the loan, and your comfort level with risk. Whether it's a HELOC, personal loan, or refinancing, understanding each option can empower you to make the best decision.