Home Equity or HELOC: Which Loan Is Best for You?

11/16/2005

Say you own your home and it's worth more now than it was when you bought it. Let's also say you need money now for a new roof or will need it when the twins go to college in a couple of years. How do you tap into that equity without selling your house?

There are two basic ways to pull cash out of your home without actually selling it: home equity loans, and home equity lines of credit or HELOCs. Although they are similar in some respects, they differ greatly in others. It's important to understand these attributes so you can pick the loan that is best for you and your needs.

First, let's look at the similarities. For most people, the interest paid on home equity loans and HELOCs is tax-deductible, just like with first mortgage loans. Also, the interest rate charged for these loans typically is lower than other forms of consumer financing, such as credit cards and personal loans. And neither loan type dictates how you spend the money.

But there are big differences between the two that you need to understand. A home equity loan is another name for a second mortgage. You get a lump-sum check for X amount of money, and it comes with a fixed repayment program that spells out the interest rate, the size of the monthly payments, and how long you will have to make them. As with a fixed-rate mortgage, neither the interest rate nor the monthly payment will change during the life of the loan.

A HELOC is more flexible but also can be more volatile, since the interest rate can change several times over the life of the loan. You take out money as you need it, and you pay it back as you can. You pay only the interest on the amount that you owe at any one time, and you can take money out and pay it back over and over again.

It is an ongoing line of credit, explains Terence Roche, a partner in Cornerstone Advisors, a bank consulting firm in Scottsdale, Ariz. Roche, a former banker, says that the reason you want the money will determine which type of loan you should get.

If you are doing a major home remodel, putting in a swimming pool, or if you have any other reason that you need a large sum of money all at once, then a home equity loan is what you probably want, he explains, especially if you want to have a fixed interest rate and terms.

A HELOC is for people who might not have a particular need for a loan at the moment but who want an open credit line guaranteed by the value of their home. They are less concerned, ultimately, about their rates or payments, and they can live with the fact that the interest rate can change with a HELOC.

One point that most people might not know about HELOCs, however, is that most of them will convert to a fixed-rate loan, usually after 10 years, Roche says. The interest rate then will lock in at whatever the rate is when it converts, and your payments will be fixed. If you do not owe anything on the loan at the time, then it is considered paid. If you still want access to your equity through a HELOC, you would have to go out and open another one.

Roche says that a HELOC, which usually comes with an annual fee or service charge of around $50 or $75, gives you access to your equity funds anytime you want it. While most HELOCs come with a checkbook, today more and more lenders are issuing debit cards instead of checks. I know that I'm not that disciplined," he added. "If I had that in my pocket, I would find too many ways to spend it.

HELOCs also have another noteworthy characteristic: most of them are interest-only. That means all you have to pay is the monthly interest, which can be a benefit or a pitfall. Certainly, the interest amount you pay will be a lot lower than it would be if you owed that money to a credit card company. And that interest is tax deductible. But if all you ever pay is the interest, you will never reduce the size of the loan. You will just keep paying monthly interest payments and eventually, when the loan converts to a fixed-rate loan, you will still face the same sort of monthly payments that you would have had on a home equity loan.

This doesn't mean a HELOC is a bad loan; it just means it can be a dangerous one if you don't know exactly what you are doing-or plan to do-when you take out one.

Since a home equity loan, like a HELOC, is usually a second mortgage, the rate you pay will probably be a little bit higher than the rate you could get for a first mortgage. This, however, is not always the case. Someone whose home is completely paid for would get a better rate than someone looking at a second mortgage payment.

It is very easy to get either a home equity or HELOC right now. Roche says. You can get a provisional or conditional answer in a couple of days, subject to a property assessment, and have the loan funded in 30 days. He advises shopping around and looking at more than just the interest rate. Look at the loan origination fees, points, and at all the other charges. If you're looking for a HELOC, check out what the annual fee will be with different lenders.

Thanks to the Internet, It is now a national market. You can be in Florida and get a loan from a lender in Maine, Vermont or California," he adds. "Go to an Internet search engine. Type in national HELOC or home equity rate, and see what you get. People have a lot of choices today.

If you own your home, the equity in it is yours to use as you see fit. So when you do decide to take out some of the equity in your home, make sure you find the type of loan -- home equity or HELOC -- that best fits you and your needs.