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Home Equity Loan vs Home Equity Line of Credit

There are advantages and disadvantages to both home equity loans (HELs) and home equity lines of credit (HELOCs), making the choice between the two dependent on your unique needs and circumstances.

Amount You Can Borrow

Both home equity loans and lines of credit allow you to borrow up to 100% of the equity in your home. In some cases, lenders will even allow you to borrow up to 125% of your home equity.

Qualifying Requirements

Both HELs and HELOCs require you show proof of the following:

* personal income;

* ownership of the home ownership (ie. Title);

* current mortgage;

* current value of the home (via a professional appraisal).

A home equity loan additionally requires proof that at least 20% of the home’s value has already been paid off. So, if you have yet to pay off at least that much of your home’s value, then your choice of which instrument to apply for is made for you.

Purpose for the Money

If you wish to use the money borrowed in a lump sum for a single, one-time expense (ie. a particular renovation, an emergency, a desired purchase, or to consolidate debt), then a home equity loan may be the better choice.

If you don’t have a single, particular use for the money in mind and don’t think you’ll need the money all at once but rather feel that you’ll be needing it on a periodic basis (ie. for lengthy and drawn-out remodels, medical bills, or college tuition payments that will be made in intermittent sums), then a home equity line of credit may be the better choice.

The HELOC gives you a flexibility that a home equity loan does not, allowing you to borrow however much you need, at the time that you need it, rather than taking out more than you need at once and, subsequently, paying interest on the whole amount from day one. Rather than receiving a fixed lump sum all at once, with a HELOC, you’re usually given checks or a credit card to use on an as needed basis. Part of the risk inherent in home equity lines of credit is that you could end up borrowing more over time that you can realistically pay off.

Interest Rate and Monthly Payments

Both HELOCs and HELs generally carry lower interest rates than conventional bank loans and credit cards, as they are secured by borrowing against your home. They both, however, commonly carry interest rates higher than that of your primary mortgage (or first mortgage). Interest on both instruments may be tax deductible (to find out, check with your tax advisor).

Interest paid on both of these instruments (HELs and HELOCs) is also usually tax deductible, whereas interest paid on conventional bank loans and credit cards is not.

The interest rate and monthly payments on a home equity loan is fixed, allowing you to budget accordingly, though in many cases you could opt for an adjustable rate (though that isn’t always advisable). The payment term on a home equity loan is also fixed, meaning that you must pay it off in full by a predetermined point in time.

The interest rate and monthly payments on a home equity line of credit is not fixed and will fluctuate over time, based on fluctuations in the prime rate, so budgeting accordingly can be much more challenging. The interest on a home equity line of credit is also typically higher than that of a home equity loan. The payment term on a home equity line of credit, however, is not fixed, and so long as you keep making minimum payments, you could conceivably stretch out the payment period indefinitely.

Closing Costs

Like other loans, a home equity loan comes with certain closing costs that must be covered in advance of receiving the loan.

There are usually no closing costs involved in a home equity line of credit, though you may have to pay an annual fee.

Collateral

Remember, that in either case, your home is considered the collateral for payment.

Home Equity Loans – Are They Still Available?

The home equity loan market has shrunk along with many Americans’ home equity, meaning that arranging a loan secured by the house value has become increasingly difficult and expensive. Here, I will explore the reasons behind this situation.

Falling home values

Home equity is the term used to describe the portion of the home that is actually owned by the homeowner. So, as an example, if some one owns a $200,000 home and has borrowed no money against it, they would have $200,000 of equity in the home. As another example, some one who owns a $200,000 home, yet has an outstanding mortgage on the property of $100,000 would have $100,000 in equity. Simple mathematics.

Now to a more realistic example – Some one has purchased a $200,000 house, using a $180,000 mortgage, and the home has since fallen in value by 25% to $150,000. They would now be considered to have “negative equity,” in that they owe more money on the house than it is worth. They have no equity in the house and will not be getting a “home equity loan.”

Home values in the USA have fallen to around 2003 levels, meaning any buyer who purchased a home using a mortgage in the last six years is almost certain to have no equity. In fact – at the time of writing this (August 2009), only 5% of American homeowners with a mortgage have positive equity in their home. The other 95% are underwater, and almost 14% have more than -25% equity. None of these people are going to be able to arrange a loan, because they hold no equity.

Increased lending criteria

As the banks have continued to suffer heavy losses, and the amount of foreclosures continues to increase, they are being forced to return to rational lending practices. The 100% home equity loan is a thing of the past, along with the so-called “liar loans,” and 125% Jumbo loans.

This they have increased their lending criteria to the point where they will only consider a home loan of 80% of the value of the home. Once the fact that home values have fallen drastically is taken into consideration, this means the home equity loan is a rare beast.

In summary, the home equity loan market is unlikely to pick up in the near future, for the simple fact that very few have any home equity to borrow against. This does not mean that it is impossible to arrange a home equity loan, but it is important to know the value of the home and actually have some equity. This is another issue currently being faced – with falling sales volumes, it is becoming increasingly difficult to accurately value any real estate, and therefore more difficult to accurately assess the level of equity. One thing is for certain; the banks will err on the side of caution when doing so. Homeowner loans are currently only available to borrowers with a “good” credit score and equity to borrow against.