Decision Time: Home Equity Loan or Home Equity Line of Credit?
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%, 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.
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