Understanding the Difference Between Home Equity Loan Options

Homeowners interested in taking out a home equity loan or HELOC should do their homework before making a decision.

Sep 8, 2011

Each time a homeowner makes a mortgage payment, they begin to build equity, which can serve as a lifeline down the road. When homeowners are facing financial hardship or need cash to make a large purchase, many turn to their homes as a source of funding. In what’s usually termed a second mortgage, homeowners may decide to take out a home equity loan or a home equity line of credit, or HELOC. However, there are differences between the two options and it’s important that homeowners understand them before meeting with their banking representative.

Both types of loans are secured by a consumer’s property and are generally used for a shorter time period than a homeowner’s first mortgage, ranging from five to 15 years.

A home equity loan is a one-time, lump sum payment made to the homeowner. The loan carries a fixed interest rate, allowing consumers to make payments in the same amount each month, and the loan must be paid off in a pre-determined amount of time. Consumers who take out a home equity loan are prohibited from borrowing further from their home. As such, these loans are generally better suited for consumers who plan to use the money for a purchase with a fixed price tag. For example, if a homeowner has a medical bill that is exactly $10,000 they may be better off borrowing this one-time, finite amount from their home’s equity. But a consumer who is undertaking a remodeling job that may come with hidden or extra costs may consider taking out a home equity line of credit.

A HELOC, in contrast, allows homeowners to borrow up to a certain amount for the duration of the loan term, which is generally set by the lender. Similar to a credit card, the HELOC loan will serve as a revolving account and allow consumers to withdraw what they need, pay down the principal, then withdraw again. Because of the added flexibility of a HELOC, consumers who do not know the final price of their financial undertaking would benefit from this type of financing. Some homeowners use them to cover tuition, home improvements or ongoing medical bills. Unlike home equity loans, HELOCs carry variable interest rates that fluctuate over time, making it important for consumers to keep up with their payments. Homeowners are required to pay off the full balance when the life of the loan expires.

Consumers should also take fees into account before opening up a HELOC. For example, homeowners will generally be required to pay a non-refundable application fee and expenses associated with appraising the value of the home. Some banks may also impose upfront charges, such as one or more points. One point may equal 1 percent of the line of credit, according to the Federal Reserve. Lastly, consumers will likely pay traditional fees that accompany taking out a mortgage, such as closing costs, attorney expenses, title fees and others.

Homeowners interested in taking out a home equity loan or HELOC should do their homework before making a decision. Most banks offer online programs that provide a snapshot of interest rates, loans terms, associated fees and conditions. Additionally, consumers are advised to meet face-to-face with a banking representative to determine which type of loan best suits their needs and to discuss interest rates.

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