By Tim Paul
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 percent, following a torrid 31 percent 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) loan. 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
loan 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 loan, 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 loan 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 loan 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, HELOC loans 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 percent of consumer credit accounts followed by personal
loans (23 percent) and regular home equity loans (16 percent).
In terms of dollar value, home equity credit accounts (HELs and
HELOCs together) represent a full 75 percent of consumer credit
portfolios with HELOCs having a 45 percent share of the market
and HELs a 30 percent 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 is a financial management executive
with more than 25 years experience. His websites focus on
personal finance issues and include http://www.sagetips.com,
http://www.529rewards.com and,
http://www.reverse-mortgage-information.org.
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