Tapping Your Home's Equity: Line or Loan?
You may not realize that if you want to tap the equity in your home you have two types of loans to choose from: an equity line of credit or equity loan.
The most popular is the home equity line of credit. It's commonly 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. That can be 10, 15 or 20 years. When the loan is paid off you cannot reuse if for another project. instead you apply for a new loan. Interest rates on these types of loans are usually higher because they are guaranteed fixed-rate loans.
Traditional second mortgages are more commonly used for a onetime project, such as an addition to your home. The advantage is that your 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 stuck with a balloon payment.
You can avoid a balloon payment with an equity line of credit -- as long as you pay both principal and interest through the life of the loan and the principal amount you choose to pay will be enough to pay down the loan in full.
The costs for an equity line of credit or an equity loan are similar to those for a first mortgage. Sometimes banks offer to pay some of these costs for you as part of a promotion. But, either way, when tapping equity in your home someone will have to pay:
- A fee for a property appraisal to estimate the value of your home;
- An application fee and credit check;
- Points, if required.
- Closing costs, including fees for attorneys, title search, mortgage preparation and filing, property and title insurance and taxes.
Before you even consider taking out an equity line or a loan, be sure you know how you'll pay it back. You put your home at risk when you tap it's equity because the house is collateral for the loan. If you don't make your payments on time the bank can foreclose on the property. That's why it's best to think twice if you're tapping the equity loan to pay off unsecured debt, such as credit cards. While a credit card company can't foreclose on your house, a company holding your mortgage can.
Also, if you use an equity line of credit with a variable-rate loan, remember that interest can go up and probably will in the next few years, as the economy recovers and the Federal Reserve again worries about inflation.
When the Federal Reserve starts raising interest rates, the interest rate on a variable-rate equity line of credit will increase. Be sure you can pay the higher interest rate even before you take the loan, so you don't put your home at risk.
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."