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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 disbursednot 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 worldsalmost. 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 Sagetips: Tips for Savvy Home Equity Credit Line Users
By (Guest Post)
09/01/2004
I have a HELOC. Its my only bank account and my wages are paid straight into it, saving on interest immediately as the interest is calculated daily. Because of this I also use my credit card for all purchases, (to leave the cash in the HELOC for longer), and pay everything off the card that would accrue interest each month by automatic payment. I do not need a cheque book. The only banking fees I pay are the interest on the balance owed and $12/month fee - no transaction charges for unlimited withdrawals or any deposits or direct debit bill payments scheduled from the account.
Initially my aim was to be mortgage free and by frugal living and leaving all spare cash in the loan I reduced my mortgage by 1/3 in the first year. It is very encouraging to visit the netbank each month and see your mortgage dropping fast! This disciplined saving allowed me to extend the line of credit to purchase a second house I unexpectedly fell in love with, while finishing the renovations on the first.
Now, after a year I have sold the original house - reducing my HELOC to $10,000. I will be using the equity to extensively renovate this house and purchase any large ticket items I need like new freezer, kitchen appliances, etc - bringing the HELOC up to around $30,000 - $35,000 by the end of this year. I have then given myself 18 months to pay off the HELOC and accumulate an emergency fund. I will then reduce my work hours/semi retire at 55. I am a 53 year old single nurse so not a big earner but the HELOC is the best thing I could have done.
Just paying my ordinary capital and interest mortgage was somehow 'invisible' - I never seemed to be getting anywhere! The incentive of seeing the HELOC fall each month is very motivating! The only caution I would like to stress again is you do need discipline. While renovating it is very easy to maintain the HELOC at its limit and if you carry on spending, paying only the obligatory interest, you may find yourself at retirement owing the same as you borrowed initially. I was never a big credit card user anyway so know I will achieve my goals. Interestingly the bank has told me I can maintain my HELOC for just the $12/month fee even when the loan is paid off. If I ever needed to borrow money again this would save the $600 loan set up fee.
So, all things considered, for a disciplined spender/saver, I can't recommend this method of paying off your mortgage highly enough! Just out of interest I am in Australia and bank with the Commonwealth Bank of Australia.
Regards
Jo - not a guest but forgot to log in!
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