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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.
About The Author
Tim Paul has more than 25 years executive financial management
experience. His recent area of focus has been to develop and
catalog proven strategies for financially savvy persons to get
the most from their home equity credit lines. His website is
www.sagetips.com.
mail@sagetips.com
 MORE RESOURCES updated Thu. February / 09 / 2012
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