A homeowner can use the built up home equity to avail a home equity loan or a home equity line of credit. The built up home equity, which is the difference between the market value of the home and the mortgage balance due on the house, if any, has to be positive. A negative home equity will prevent the borrower from availing a loan or a line of credit.
The difference between the loan and the line of credit became apparent in the 1980s, when the lenders started providing a loan that worked like a credit card. The new loan allowed the borrower to withdraw money as and when required during the draw period, and pay only interest on the amount withdrawn while repaying the principal balance in the repayment period. This loan gave the consumer the flexibility of borrowing in installments, like a credit card, and paying interest only on the borrowed sum. This new loan came to be known as the home equity line of credit (HELOC). A home equity loan (HEL) on the other hand, gave the borrower a lump sum money that accrued interest. The principal and interest payments on a HEL were predictable, and had to be discharged in regular monthly payments consisting of both the principal and the interest component. Since both home equity loans and home equity lines of credit could be obtained by pledging the home, that was already mortgaged, they came to be known as second mortgages.
It may behoove the reader to note that while the term second mortgage can refer to a home equity line of credit or a home equity loan, the former does not have to be a second mortgage. In other words, a HELOC can be a second mortgage or a primary mortgage. For those who are not comfortable with the difference between a primary and a secondary mortgage; a primary mortgage helps people buy a home by pledging the purchased home as a collateral, while a second mortgage helps people avail a loan/line of credit by mortgaging the already mortgaged home. As mentioned earlier, a HELOC may not always be a second mortgage. This is because the facility of refinancing the primary mortgage on the house, using a HELOC, makes the line of credit a primary mortgage. Mortgage refinancing is akin to substituting the existing mortgage with a new mortgage loan that carries a relatively low rate of interest and has favorable repayment terms.
Home Equity Loan and Line of Credit
If the reason for borrowing, using built up equity, can be attributed to the need for money to meet recurring expenses, like a series of home improvements, HELOC is the best option. A HEL would be the logical choice if the intention is to avail a loan for a one-time expense like credit card debt consolidation. This is because HEL has a non-revolving structure, hence, it does not impact the credit score as negatively as a revolving credit card debt. Again, from the perspective of credit scores, a home equity line of credit may not be advisable for a person with a poor credit score since it has a revolving credit card structure.
People who are confident of their ability to repay money in fixed installments, should opt for the home equity loan since it carries a fixed rate of interest and the borrower is obligated to make regular, predictable interest and principal payments. The loan has a maturity period of 5 to 30 years.
A HELOC allows people to withdraw money on a regular basis for a period of 10 years while paying only interest on the money that is withdrawn, thus making it akin to using a credit card. At the end of the draw period, the balance that is yet to be repaid, gets transformed to a loan with a maturity period of 15 or 30 years.
A HEL is especially advantageous if the prime rate is expected to increase in the future, since the rate of interest on a HEL is fixed, in other words, independent of the prime interest rate. In this situation, a HELOC’s interest rate will readjust to reflect the prime rate and the consumer, who otherwise benefits by discharging only the interest during the draw period, may feel the brunt of higher interest rates.
Uncertainty regarding ability to make future payments may compel people to opt for a home equity loan, since a HELOC may stretch out payments. Although one has the option of pre-paying the principal, in case of HELOC, one may be tempted to avoid paying more than the requisite amount.