Home equity is the difference between the current market value of a home and what is owed on that home by way of first and second mortgages. Homeowners can cash out some or all of this equity by increasing their mortgage balance. This can be done in one of two ways; refinancing the first mortgage or taking out a second mortgage.
A second mortgage can either be a fixed-amount loan or a home equity line of credit, known as a HELOC. Either type of home equity loan comes at a lower rate of interest than other forms of credit and has certain tax advantages. But which is best for you?
Home Equity Loan or Line of Credit?
A fixed-amount loan makes sense for people who want to make a large purchase such as a new car, to finance home improvements, or to consolidate high-interest bills. The interest rate can either be fixed—in which case the monthly payment will be the same over the life of the loan—or adjustable—in which case the interest will rise or fall with the financial index to which it is tied.
HELOCs are variable-rate loans with a set limit, just like a credit card. Homeowners can draw what they need when they need it. As a result, they only have to pay interest on the amount of credit actually being used.
Les Christie, CNNMoney.com staff writer notes that,
“Helocs are easy and inexpensive to obtain and they carried very low interest rates - until recently. But what was a bargain two years ago can be a burden today. Consider: The monthly interest payment on a loan of, say, $50,000, has more than doubled in two years, to more than $333.
“Helocs are credits that can be drawn from and typically act as interest-only loans with terms of five to 25 years after which the principal must be repaid. Interest is tied to the prime, the rate banks charge their best customers, which has soared since June 2004, to 8.25 percent from just 4 percent.”
When it comes to HELOCs, Keith Gumbinger, vice president at HSH Associates, a publisher of consumer loan information advises,
“If you're doing it to pay off expensive credit card debt, or for needed home improvement or to pay for education, there's nothing wrong with that. But many people are using it for day-to-day expenses. For them, the danger is they've been given a new tool - for digging themselves a deeper hole.”
Jack Guttentag, founder of the Mortgage Professor web site, points out that HELOCs can have a negative affect on a person’s credit score.
“HELOCs are viewed as revolving credits, similar to credit cards, where there is a balance and a maximum balance. The ratio of the first to the second is used as a measure of financial strength … Under the existing rules, a one-time pay-out loan does not affect the credit score, only the payment record does. But a HELOC taken out for the full amount at the outset will negatively affect the score at the outset.”
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