Decision
Time: Home Equity Loan or Home Equity Line of
Credit?
Home equity loans and home equity lines of
credit continue to grow in popularity. According
to the Consumer Bankers Association, during 2003
combined home equity line and loan portfolios
grew 29%, following a torrid 31% growth rate in
2002. With so many people deciding to cash in on
their home's equity value, it seems sensible to
review the factors that should be weighed in
choosing between out a home equity loan (HEL) or
a home equity line of credit (HELOC). In this
article we outline three principal factors to
weigh to make the decision as objective and
rational as possible. But first, definitions:
A home equity loan (HEL) is very similar to a
regular residential mortgage except that it
typically has a shorter term and is in a second
(or junior) position behind the first mortgage
on the property - if there is a first mortgage.
With a HEL, you receive a lump sum of money at
closing and agree to repay it according to a
fixed amortization schedule (usually 5, 10 or 15
years). Much like a regular mortgage, the
typical HEL has a fixed interest rate that is
set at closing for the life of the loan.
In contrast, a home equity line of credit (HELOC)
in many ways is similar to a credit card. At
closing you are assigned a specified credit
limit that you can borrow up to - not a check.
HELOC funds are borrowed "on demand" and you pay
back only what you use plus interest. Depending
on how much you use the HELOC, you will have a
minimum monthly payment requirement (often
"interest only"); beyond the minimum, it is up
to you how much to pay and when to pay. One more
important difference: the interest rate on a
HELOC is adjustable meaning that it can - and
almost certainly will - change over time.
So, once you've decided that tapping your home's
equity is a smart move, how do you decide which
route to go? If you take time to honestly assess
your situation using the following three
criteria, you will be able to make a sound and
reasoned decision.
1. Certainty or Flexibility: Which do you value
the most?! For many borrowers, this is the most
important factor to consider. Your home is
collateral for either type of home equity
borrowing and, in a worst case scenario, it
could be seized and sold to satisfy an
outstanding unpaid loan balance. People do
remember the double-digit interest rates of the
early 1980's and, for many, the mere prospect of
interest costs on a variable-rate home equity
line of credit rising rapidly beyond their means
is reason enough for them to opt for the
certainty of a fixed rate HEL.
From the borrower's perspective, "certainty" is
the main virtue of a fixed-rate home equity
loan. You borrow a specific amount of money for
a specific period of time at a specific rate of
interest. You repay the loan in precise monthly
installments for a precise number of months. For
many, knowing exactly what their future
obligations will be is the only way they can
borrow against the equity in their home and
still sleep at night.
A home equity line of credit, in contrast, is
short on certainty but long on the virtue of
flexibility. With a HELOC you borrow funds on an
irregular schedule that meets your needs at
adjustable interest rates that can change
quickly. Loan repayment is also flexible: you
typically are required to make only relatively
small "interest-only" monthly payments on a
HELOC. However, you have flexibility to make any
size payment above the interest-only minimum or
payoff the loan at your will.
2. Do you need money for a one-time, lump-sum
payment or will your cash needs be intermittent
over several months or years? Home equity loans
are best suited for one-time payment needs (a
good example is consolidating debt by paying off
several high-rate credit cards at one time).
This is because at the time you close on a HEL,
you will be provided with a lump-sum check in
the amount you've borrowed (less closing costs).
While it may be empowering to have that much
money handed over to you, be humbled by the fact
that you will immediately begin incurring
interest costs on the entire balance.
When you close on a HELOC, on the other hand,
you will be given a checkbook (or debit card)
that you use only as needed. So, for instance,
if you're embarking on a multiyear home
improvement project for which you'll be writing
checks at varying times, a HELOC might be best.
Similarly, a credit line is probably best for
paying sporadic college expenses. Interest on a
HELOC is only charged from the time that your
HELOC checks clear the bank and only on amounts
actually disbursed…not the value of the entire
credit line.
3. Do you possess sufficient financial
self-discipline for a HELOC?
Financially-disciplined borrowers can have the
best of both worlds…almost. By taking out a
HELOC but paying it back according to a
self-imposed fixed amortization schedule they
can enjoy both the flexibility of borrowing cash
only as needed and the certainty of a fixed
repayment schedule. HELOCs are typically more
efficient in terms of lower closing costs and a
lower initial interest rate. Also, a HELOC may
be somewhat easier for borrowers to qualify for
since the low, flexible monthly payments mean
debt to income ratios that loan officers look at
are more favorable for the borrower.
The one big factor not within the HELOC
borrower's control is the interest rate (see #1
above). Interest rates will almost certainly
change over the life of a HELOC. This means that
a self-imposed "fixed" amortization schedule may
need to be periodically refigured. Numerous
internet sites provide free, powerful mortgage
calculators that can assist you in preparing
updated amortization schedules whenever needed.
Some lenders are also meeting borrowers' demand
for greater certainty by providing HELOC
products that can be converted (for a fee) into
a fixed rate loan when the borrower elects.
As mentioned earlier, HELOCs are much like
credit cards and the similarity extends to
spending temptation. If you are a person who has
trouble keeping credit card debt under control
and you haven't taken steps to change habits,
then a HELOC probably isn't a smart choice.
You might be wondering which home equity product
most people actually choose. According to the
Consumer Bankers Association 2002 Home Equity
Study, home equity lines of credit account for
28% of consumer credit accounts followed by
personal loans (23%) and regular home equity
loans (16%). In terms of dollar value, home
equity credit accounts (HELs and HELOCs
together) represent a full 75% of consumer
credit portfolios with HELOCs having a 45% share
of the market and HELs a 30% share. Of course,
the popularity of HELOCs may subside if interest
rates continue to rise.
Whichever home equity product you decide on be
certain to shop for the best deal possible. The
market is extremely competitive and there are
many non-traditional options, including on-line
lenders and credit unions, which should be
considered in addition to your local bank.
This article is the property of
www.1st-in-homeloans.com, which has been
offering home mortgage services since 2002. To
find out more visit
www.1st-in-homeloans.com
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