Selection of a home equity loan or a line of credit

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Choosing a home equity loan or a line of credit

Do you need a way to pay for major expenses, such as sending your child to college or renovating your kitchen? Or would you like to eliminate those outstanding credit card balances once and for all? The answer could literally be in your own backyard. If you have enough equity in your home, you can borrow against it for a low interest rate; as a bonus, the interest payments are generally tax deductible.

There are two basic ways to use your residence as collateral: a home equity loan and a home equity line of credit (HELOC). Here are the points you should consider when choosing between them. (for a brief introduction, see home equity loans vs. HELOC: the difference ).

What is the money for?

First question: what is the purpose of the loan?? A home equity loan, sometimes called a home equity installment loan, is a good choice if you know exactly how much you need to borrow and what you will use the money for. You are guaranteed a certain amount, which you receive in full at closing. "Home equity loans are usually preferred for larger, more expensive goals like remodeling, paying for higher education or even debt consolidation because the funds are received in a lump sum," says richard airey, a loan officer with finance of america mortgage in portland, maine. Of course, when applying, there may be some temptation to borrow more than you need immediately, since you only get the payout once and you don't know if you will qualify for another loan in the future.

Conversely, if you're not sure how much you need to borrow and when, a HELOC is a good choice. Generally, for a set period of time (sometimes up to 10 years), you get continuous access to cash. You can borrow against your line, pay it back in full or in part, and then borrow the money back later while you're still in the HELOC's introductory phase. However, a credit line is revocable. If your financial situation worsens or the market value of your home declines, your lender may decide to lower your line of credit or close it altogether. While the idea behind a HELOC is that you can access funds as you need them, your ability to access that money is not a sure thing. "Helocs are best suited for shorter-term goals, say 12 to 20 months, because the [interest] rate can fluctuate and is generally tied to the prime rate," airey says.

Factors of interest

For years, an important factor in whether to get a home loan or a HELOC was the interest rate. Rates on helocs were typically at least a full percentage point lower than the interest rate on home equity loans, making it tempting to choose the HELOC, even though the interest rate is variable, while the interest rate on one is below).

Today, however, helocs have little advantage over home equity loans. According to bankrate's weekly survey of significant lenders for the 9. September 2015 had a home equity loan with a volume of 30.000 $ an average interest rate of 5.22%. All things being equal, HELOC had an average interest rate of 4.75%. Difference of less than half a percent. (learn more about an important factor that affects interest rates in. How federal open market committee meetings boost prices and stocks.

However, not only do you have to consider the current interest rate differential, but interest rates are headed. If you think it will stay the same or decrease, you might opt for the lower rate of HELOC. If you think interest rates are rising, a home equity loan might be the way to go. In fact, analysts expect interest rates to rise in the near future, so easing today's low rates on equity securities could make a lot of sense. (see understanding home equity loan rates for more.)

Amortization period

It's also important to consider how each loan is structured. A home equity loan works like a traditional fixed-rate mortgage. You borrow a fixed amount at a fixed interest rate and make equal payments for the entire loan term, which can range from five to 30 years. Regardless of the period, you'll have stable, predictable monthly payments for the life of the loan.

In contrast, a loan term on a HELOC consists of two parts: an underwriting period and a repayment period. The draw period during which you can withdraw money can last 10 years and the repayment period can last another 20 years, making the HELOC a 30-year loan. Once the draw period ends, you can no longer borrow money.

During the HELOC draw period, you will have to make payments, but they are usually small, which often means you only pay back the interest. During the amortization period, payments become much higher because you are now paying back the principal amount. The U. S. Bank, for example, lets its HELOC borrowers choose to pay either interest only or 1% or 2% of the outstanding balance during the draw period. During the 20-year repayment period, you must repay all the money you borrowed plus a variable interest rate.

This increase in payments at the beginning of the new period has resulted in payment shock for many unprepared HELOC borrowers. If the sums are large enough, it might even lead to those in financial distress situations. And if they default on payments, they could lose their homes – the collateral for the loan, remember.

The long view

If you're the kind of person who looks at your financial decisions in the big picture, a home equity loan might make more sense. Since you're borrowing a fixed amount at a fixed interest rate, taking out a home equity loan means you know how much you'll spend on the loan in the long run the minute you pay it off (although you can reduce that amount). If you're paying off the loan early or refinancing at a lower interest rate). Borrow $30, 000 at 5.5% for 20 years and you can easily calculate that the total loan cost, including interest, will be $49, 528.

With a HELOC, you know that the most you can potentially borrow is the amount of your credit limit, but you don't know how much you'll actually borrow. You also don't know what interest rate you will pay. That means it's difficult to calculate the long-term cost of a HELOC.

Of course, it might be easy to build a HELOC into your big picture if you just want to have a line of credit on hand and you don't want to do much with it. But if you plan to use the HELOC heavily and know what your net worth might look like in 20 years, that's much harder to anticipate.

The best of both worlds

Cannot choose between the two vehicles? Don't fret: there are ways to get some of the stability of a home equity loan with some of the flexibility of a HELOC. Some lenders give borrowers the option to convert a HELOC balance to a fixed-rate loan. For example, you can use the U. S. Bank a fixed interest rate for terms such as 15 or 20 years for all or part of your variable rate balance. You can have up to three time deposit balances at any one time. Bank of america and wells fargo also offer fixed-rate options on their helocs (using them, in effect, as a replacement for home equity loans, which they no longer offer).

Pentagon federal credit union, one of the largest credit unions in the country (which anyone can join for a small fee) offers another interesting option: a 5/5 HELOC, where the interest rate changes only once every five years.