There are two types of home equity loans: term, or closed-end loans, and lines of credit.
Both are sometimes referred to as second mortgages, because they’re secured by your property, just like your original (first) mortgage.
Home equity loans and lines of credit are usually for a shorter term than first mortgages. The most common type of mortgages runs 30 years, while equity loans typically have a life of five to 15 years.
A home equity loan, sometimes called a term loan, is a one-time lump sum that is paid off over a set amount of time, with a fixed interest rate and the same payments each month. Once you get the money, you cannot borrow further from the loan. To see current home equity loan rates, use Bankrate’s home equity loan rates tables.
A home equity line of credit (HELOC) works more like a credit card. You are allowed to borrow up to a certain amount for the life of the loan — a time limit set by the lender. During that time you can withdraw money as you need it. As you pay off the principal, your credit revolves and you can use it again. Let’s say you have a $10,000 line of credit. You borrow $5,000, but then pay back $3,000 toward the principal. You now have $8,000 in available credit. This gives you more flexibility than a fixed-rate home equity loan.
Credit lines have a variable interest rate that fluctuates over the life of the loan. Payments will vary depending on the interest rate and how much credit you have used. When the life span of a line of credit has expired everything must be paid off. A lender may or may not allow a renewal. To see current home equity line of credit rates, use Bankrate’s home equity line of credit rates tables.
Lines of credit are accessed by specially issued checks or a credit card. Lenders often require you to take an initial advance when you set up the loan, withdraw a minimum amount each time you dip into it and keep a minimum amount outstanding.
Financial institutions negotiate a home equity loan just like they do a mortgage: You have to pay off the loan or line of credit when you sell the house.
Which type should you choose?
The answer to this question is seldom black and white.
But there are some scenarios where the choice is obvious. For example, let’s say you need $7,000 to pay for your daughter’s wedding next month and $3,000 to fix your roof, which will take a week. You know exactly how much you need and both amounts are due in full fairly quickly. If you don’t have plans to borrow again, a straight home equity loan for $10,000 is more suited to your purpose.
But if you need money over a staggered period of time — for example, at the beginning of each semester for the next four years to pay for Jimmy’s schooling or for a remodeling project that will take three years to finish — a line of credit is the better choice. It gives you the flexibility to borrow only the amount you need, when you need it.
And if you borrow relatively small amounts and pay back the principal quickly, a line of credit can cost less than a home equity loan.
Credit card debt consolidation
Consumers who have run up credit card debt will often borrow a lump sum and pay off their Visa, MasterCard and department store charges, then pay back the bank over time at a lower interest rate than the cards would have imposed. This sort of debt consolidation is the single most-popular reason people have for taking out home equity loans, and fixed-rate home equity loans are used slightly more often for this purpose lines of credit.
To help you determine which loan best suits your needs, ask yourself:
- When do I need the money?
- For how long do I need the money? Is it for a short-term purpose, or a long-term?
- How long do I need to pay it off?
- How big a monthly payment can I handle?
- Would a line of credit tempt me to use the money carelessly because it works similar to having a charge card or checking account?
Ask your lender:
- How long is the term of the closed-end loan?
- What is the life span of a line of credit?
- How large a line of credit do I qualify for?
- Is my line of credit renewable when the life of the loan expires?
- What are the interest rates?
- Do I have to use my credit line right away? (If you’re opening a credit line for future or emergency needs, you’ll want one that doesn’t require a minimum draw at closing.)
- Under what circumstances can you freeze, reduce or demand full payment of my loan?
- Can I lease my house during the time of the loan?
- Will you loan to me if my house is on the market (and at what rate)?
- If interest rates go down, how low will my loan go?
Looking for alternatives to using home equity? Consider a personal loan – Find the Lowest Personal Loan Rates