Here are two types of equity loans: term, or
closed-end loans, and lines of credit.
Both are technically "second mortgages,"
but that description most commonly refers to term
equity loans. When you are paying on an equity
loan, you have two active mortgages and make two
separate payments. The first, of course, is your
original mortgage.
Second mortgages and lines of credit are usually
for a shorter term than the mortgage you used
to buy your home in the first place. First mortgages
typically run up to 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.
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.
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 second
mortgage 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 in a reasonable amount
of time, a line of credit can cost less than a
home equity loan.
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?
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