HELOC vs. personal loan: a lower rate for a much bigger risk?

A HELOC is usually cheaper than a personal loan because your house backs it, but it puts the house at risk, its rate floats, and its low early payments can stretch the debt for decades. A personal loan costs more in interest but has a fixed payment, a fixed end date and no lien on your home. The HELOC is the better choice when you have ample equity, steady income and a plan to repay on a schedule you set yourself; otherwise the personal loan’s higher price buys real protection.

How each one works

A home equity line of credit is a revolving line secured by your home. During the draw period, often 10 years, you borrow what you need, repay and borrow again, and many lines require only interest payments. After that comes the repayment period, often up to 20 years, when the line closes and you pay principal and interest. Some lines instead require the full balance at the end of the draw period, so read the terms.

The rate is almost always variable: an index, usually the prime rate, plus a margin set by the lender. Banks’ prime rate moves with the Federal Reserve’s federal funds target. For reference, the effective federal funds rate is:

How much you can borrow depends on your equity. Lenders cap the combined balance of your mortgage and the line at a share of the home’s value. If your home is worth $400,000, you owe $250,000 and the lender allows 80%, your maximum line is $70,000.

A personal loan is an unsecured lump sum with a fixed rate and fixed monthly payments, usually over two to seven years. Approval rests on your credit, income and existing debts. This is the Federal Reserve’s average APR on a 24-month personal loan at commercial banks:

A worked comparison on $40,000

Say you need $40,000 for a kitchen. The rates below are examples: a personal loan at an APR of 12%, and a HELOC at a rate of 8.5% that stays put.

Repaid in five years, the HELOC saves about $4,147 in interest, or roughly $3,647 if you spend $500 on an appraisal and closing costs. A two-point rise in the rate cuts the saving by more than half. And if you pay only what the HELOC requires, the same $40,000 costs nearly six times as much interest as the personal loan, because the principal does not start falling for 10 years. The cheap rate pays off only if you repay on a schedule as fast as the loan you are comparing it with.

The step from interest-only to full payments is also a shock in its own right: in this example the payment rises 22.5% the month the draw period ends, and more if rates have risen.

What you put at risk

A HELOC is a lien on your home. If you fall behind, the lender can foreclose, even if you are current on your first mortgage. Turning card debt into a HELOC balance therefore swaps a debt that can damage your credit for one that can cost you your house; that move makes sense only if the spending that created the debt has stopped. The broader comparison of collateral and its consequences is in secured vs. unsecured loans, and the consolidation math is in debt consolidation loans.

The line itself is not guaranteed either. Under Regulation Z, the lender can freeze or reduce your line if the home’s value falls significantly below its appraised value, or if a material change in your finances gives it reason to believe you cannot repay, so it is a poor substitute for an emergency fund in a downturn.

A personal loan you cannot repay damages your credit and can lead to a lawsuit and wage garnishment, but no one can take your house over it without first winning a court judgment, and in many states a primary residence has some protection from judgment creditors.

Taxes, fees and the right to cancel

Under current IRS rules in Publication 936, HELOC interest is deductible only if you itemize and the money was used to buy, build or substantially improve the home that secures it. A kitchen renovation can qualify; paying off cards or a car cannot. Personal loan interest used for personal expenses is not deductible.

A HELOC can carry an appraisal fee, closing costs, an annual fee, and a charge if you close the line within the first few years. Ask for all of them in writing. Because it is secured by your principal dwelling, federal law also gives you three business days after opening to cancel without penalty.

A personal loan may carry an origination fee taken out of the proceeds; how that changes the real cost is shown in APR vs. interest rate.

Which one to choose

A HELOC is the stronger option when most of these are true:

• After the new line, you still owe no more than about 80% of your home’s value.
• Your income is stable enough that a payment two or three points higher would not strain you.
• You will repay on a fixed schedule of a few years, not the minimum.
• The money goes into the home, so the interest can be deductible, or the need comes in stages, such as tuition or a renovation paid as work is done.

Choose the personal loan when the amount is one you can repay within about five years, you need the money within days rather than the weeks a HELOC takes to close, you want a payment that cannot change, or you simply will not put your home behind the debt. If you rent, it is the only option of the two.