Home Equity Loans and Home Equity Lines of Credit
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when required, during the draw period and pay only interest on the amount withdrawn while repaying the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 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. The following write up on "Home Equity Loan vs Line of Credit"
examines the differences between the types of second mortgages.
Home Equity Loan vs 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 a
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. A home equity 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 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.