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Types of Home Equity Loans
Fundamentally, there are two types of home
equity loans.
-
Home Equity Line: When you get a home equity
line, you obtain the right to draw money, whenever you want,
over a certain period of time. You only pay interest on the
amount you borrow. You may borrow, pay off and borrow again
against the line of credit. You typically access the line with
a check or credit card.
-
Second Mortgage (home equity loan): When you
get a second mortgage, you obtain a lump sum of money. The
interest rate and monthly payments are fixed.
Home Equity Line versus Second Mortgage
|
|
Home Equity Line |
Second Mortgage |
|
Tax Deductible |
Yes* |
Yes* |
|
Annual Fee |
Yes (some lenders may waive this) |
No |
|
Draw money when needed |
Yes |
No |
|
Fixed Rate |
No** |
Yes |
Before deciding which type of loan you
want, consider how you'll use the money. If you need funds for a
single expense, such as a room addition, remodeling, etc.,
you'll want to strongly consider a fixed-rate, second mortgage.
You receive one lump sum at the beginning of the loan term.
You pay it back in equal, monthly installments.
The certainty of a fixed interest rate and equal
monthly payments make the fixed-rate, second loan very
attractive. Will this type of loan be less expensive compared to
an adjustable rate, home equity line? There is no way to know
with certainty. One would have to be able to predict interest
rates with accuracy. Consider one of the reasons why adjustable
rate loans were invented: to shift interest rate risk from the
lender to the borrower. When market interest rates rise above
the interest rate on your fixed-rate mortgage, the lender is
effectively losing money on your mortgage and you're getting a
bargain. Lenders wanted a way to protect themselves from this
situation--thus the adjustable-rate mortgage.
If you need periodic amounts of money over time,
for a child's education tuition, for example, a home equity
line may be ideal. You can borrow only the amount you need, when
you need it. These loans carry adjustable (ARM) rates, but some
banks allow you to convert a portion of your loan to a
fixed-rate second. You may pay a premium for the convenience of
an equity line, including a transaction fee for each draw and an
annual fee if you draw or not.
Deciding in advance which type of loan is best
for you helps when comparing the expense of various loans. Since
the APR for a fixed-rate second is calculated differently
compared to a home equity line, APR comparisons can be difficult
when comparing a fixed-rate second to a home equity line. APRs
of fixed-rate seconds account for points and other closing
charges. APRs for home equity lines don't account for points
and other closing costs. When comparing the same types of loans
(apples to apples), APRs are much more meaningful.
* Interest may be fully deductible. Consult
your tax advisor regarding your particular situation.
** Under certain circumstances, some loan programs let you
convert part of your home equity line to a fixed-rate, home
equity loan. |
