Home Equity Loans: Fixed or Variable Rates?
While selecting a fixed-rate mortgage loan is usually the best choice in today's market, the decision is not as clear when you're tapping your home's equity for a home equity line of credit or a home equity loan. You can save about 2.5 percent in interest by choosing an equity line, which gives you the flexibility of using it for one project, paying it off and then using it again for another project. With the interest rate savings, you can pay off that variable-rate equity line faster than you could a fixed-rate equity loan, as long as interest rates don't jump.
In today's market, the average interest rate for a $50,000 variable-rate home equity line is 4.83 percent. If you don't want the risk of a variable rate, you'll have to pay 7.24 percent to get a fixed-rate home equity loan for the same amount.
Let's take a quick look at the difference between these two types of loans, then compare payments. The most popular type of loan for tapping one's equity is the home equity line of credit. It's usually a variable-rate interest line of credit on which you pay just the interest over a term of 10 or 15 years. At the end of the term you have what is called a balloon payment that you can either pay off with cash or refinance into a new loan or line of credit. You also can pay off and reuse this credit throughout the life of the loan.
The more traditional type of equity loan is a fixed-rate second mortgage on which you pay both interest and principal, with the intent of repaying the loan in full at the end of the loan's term--10, 15 or 20 years. When the loan is paid off you cannot reuse if for another project. Instead you must apply for a new loan. Interest rates on these types of loans are usually higher because they are guaranteed fixed-rate loans.
Most people choose a traditional fixed-rate second mortgage when planning a one-time project, such as a home addition. The advantage is that the payment on this loan includes principal and interest, so you know the loan will be paid off at the end of the term and you won't be facing a balloon payment.
You can avoid a balloon payment with a home equity line of credit, as long as you pay both principal and interest through the life of the loan and the principal amount is enough to pay down the loan in full.
So how will a variable rate help you get that loan paid off faster? For example, the 15-year payments on the lower interest $50,000 home equity line of credit would be $390.98, if you want to pay it off in full. But if you take a home equity loan you'd be making payments of $394.89 to pay off a $50,000 fixed-rate home equity loan over 20 years. So the lower interest rate would mean you could pay less and be finished paying the debt five years earlier.
There is a catch, though. The payment for the fixed-rate equity loan will never change. The interest rate is guaranteed for 15 years. The interest rate for the variable-rate equity line can change much more frequently depending upon the terms of your contract with the bank. Most of these loans are set to a particular interest rate, such as prime or prime plus 1 percent or more. So when that interest changes, the interest rate on your variable-rate equity line will change.
If you're planning to do a home improvement, pay it off as quickly as possible and then do another, there's no question that the lower interest rate for a home equity line is your best choice. But if you're doing a major project that you want to pay off over 15 or 20 years, you're still better off locking in those long-term fixed rates, even if the rate is higher right now. We don't know when interest rates will jump dramatically, but we do know they're at their historic lows and starting to inch up.
Lita Epstein has written more than 25 books including The Complete Idiot's Guide to Personal Bankruptcy and The Complete Idiot's Guide to Improving Your Credit Score.