Even now, HELOC can be best choice

The massive amount of home equity borrowing in recent years has been done primarily via variable-rate home equity lines of credit. But a variable-rate product illustrates the drawback to borrowing at one rate and later repaying debt at higher interest rates. So the conventional wisdom would suggest that a borrower needing a lump sum should undoubtedly opt for a fixed-rate home equity loan. However, this is not always the case.

What about borrowers only expecting to need the money for a few years? Which product is preferable -- the fixed-rate home equity loan or the variable-rate home equity line of credit, or HELOC, -- and how do you decide?

Consider a borrower needing $30,000 but for less than a three-year period because he or she expects to either pay off the balance with one lump sum or sell the home at that time.

We will compare a fixed-rate 10-year home equity loan at 7 percent vs. a HELOC currently at 6 percent, but with the expectation that rates will increase by one-quarter percentage point every three months for the next two years.

If the borrower can diligently make both principal and interest payments every month, raising the payment as needed when rates rise to remain on a 10-year repayment schedule, the HELOC can still be the better choice for short-term borrowing needs. Under this scenario, at any time during the first 28 months, the HELOC borrower would have a lower interest tally, need a smaller lump sum to pay off the balance and have a slightly larger resulting equity stake than a borrower taking a fixed-rate home equity loan. Beyond that point, the scales begin to slowly tip in favor of the fixed-rate loan.

Remember, this is a workable strategy only if you pay principal along with the interest. The borrower reduces the impact of rising interest rates by repaying a portion of the principal each month. It is the steady repayment of principal during the loan's early years that makes this a viable alternative to taking a fixed-rate loan at the outset.

The other aspect that bears pointing out is the pace of interest rate increases. Should interest rates increase at a faster pace, this strategy would become less attractive unless the borrower was willing to step up the monthly payments accordingly. On the other hand, if interest rates increased at a slower than expected pace, the HELOC is even more advantageous.

Choosing a fixed-rate home equity loan is not automatically the right answer for homeowners with shorter-term borrowing needs. While the differences in interest paid and equity accumulated are modest for the first five years, the flexibility to borrow more or dial down the monthly payments if needed make the HELOC appealing even if the borrowing horizon is uncertain.

For more information on hybrid home equity products that enable borrowers to repay at a fixed rate now, while having a line of credit available for other needs, see this Bankrate.com article by Holden Lewis, "Line blurs between home equity loans, lines of credit."