Home equity loan Options
Home Equity Line of Credit vs. Traditional Second Mortgage
You are a homeowner with a good record of payments on your mortgage. But, as can sometimes happen in life, you are faced with a situation where you need extra cash. Perhaps you have school tuition to pay, or you want to undertake a home remodeling project. You know that you have some equity in your home and you wonder whether you can access that equity and use it as collateral for a loan. But the terminology you have heard is confusing; do you want a second mortgage or a home equity line of credit? What's the difference between a second mortgage and a home equity line of credit, anyway?
Here's the lowdown. Any loan that you take out using your home as collateral is a home equity loan. Your mortgage is a home equity loan because the lender holds the equity in your home as collateral. If you default, the lender gets your house. Both home equity lines of credit and second mortgages are forms of home equity loans. And in both cases, the amount you can borrow depends upon two factors: how much equity is in your home and your credit rating.
The differences between a second mortgage and a home equity line of credit are in how the lender gives you your money, how you pay it back, and the cost of borrowing.
How Does a Second Mortgage Work?
A traditional second mortgage is a home equity loan in which you receive one lump sum of cash at the time the loan originates, just like your first mortgage. You sign a mortgage loan for a set amount of time (typically 15, 20, or 30 years) and you are given a check for the entire loan amount. You can spend the money on anything you like and whenever you want (unless you have taken out a home improvement loan, in which case you are obligated to spend the money improving your home).
How do you pay it back? A traditional second mortgage is an installment loan, and you will be given a predetermined monthly repayment schedule. If you fall behind on your monthly payments, your credit rating will suffer and you could risk foreclosure. If you keep up with your payments, at the end of the repayment period your loan will be paid off.
Home Equity Line of Credit
A home equity line of credit is also a home equity loan, but it works more like a credit card. The lender authorizes you to borrow (or "draw") any amount up to a certain limit. The lender may provide you with a book of checks, just like you use with your checking account. The credit limit is based on a portion of the equity available in your home and your credit rating. The draw also has a time limit, often ten years. You may access the line of credit anytime during the draw period.
Lenders offer a wide variety of repayment plans for home equity lines of credit. Your lender may require a minimum monthly payment that includes a portion of the principal plus accrued interest. There may be a "balloon payment" or lump sum due at the end of the draw period. Other plans may allow the unpaid portion of the loan to roll over into your regular mortgage at the end of the draw period.
Fees and Interest Rates
Both second mortgages and home equity lines of credit involve fees, including property appraisal, application fees, one or more "points", and closing costs. But home equity lines of credit require more administrative work by the lender and may include additional fees such as membership fees, annual maintenance fees, or a transaction fee whenever you draw on the credit line. In addition, because with a home equity line of credit the lender pledges to loan you money at some point in the future, the lender is likely to offer only an adjustable interest rate. In this way the lender is protected from the rising cost of lending.
Just like a credit card, under certain conditions the lender can cut off your credit, such as if you fail to pay, if your home declines in value and your loan becomes risky, or even if your credit rating drops. Before you consider a home equity line of credit, check out the federal Truth in Lending Act and know your rights as a borrower.
When does it make sense to use a Home Equity Line of Credit and when does it make sense to use a traditional home equity loan?
Given the revolving nature of a Home Equity Line of Credit it makes sense to use this type of loan when you have a need for funds that will be ongoing. For example, if you are doing a large amount of home improvements you will probably be doing them over a long period of time and ideally you won't need the money all at once. Another example would be the start up and ongoing operation of a small business. If you are a small business owner you will periodically need an infusion of cash to help get through a cash flow crunch or fund a new initiative. In these situations it is best to have a revolving line of credit that will allow you to draw money as needed and pay money back as soon as your personal or business cash flow will allow.
A traditional (installment) type of home equity loan makes the most sense when you have a one time need for money and it is a pre-determined amount that is needed. An example of such a situation would be debt consolidation. Let's say that you have $30,000 in high interest rate credit cards that you want to pay off. This is a situation where you have a one time need for money and you know exactly how much you need.
The bottom line is - if you have equity in your home and a good credit history there will be a home equity loan product that will meet your specific needs. As always, do your homework and make sure that you are getting the right product for your situation and that you are not over paying for the loan you choose.