Generally, mortgage lenders offer two types of second mortgages:
- A fixed-rate home equity loan provides a lump sum to the borrower that must be repaid over a specific time, just like a first mortgage. Your loan payments and interest rate will remain the same until the loan is repaid.
- A home equity line of credit (HELOC) is a variable-rate loan with a set spending limit and a specific repayment date. You can borrow money from this line of credit with a credit card or checks, and when you pay down the balance you will have ongoing access to the credit line. Your monthly payments will vary according to the amount you borrow and the current interest rate.
See HSH's comprehensive Guide to Home Equity Loans and Lines of Credit
Financial goals and home equity loans
Some of the most common reasons people apply for a home equity loan are to consolidate debt and to make home improvements. In both of those cases, a home equity loan is the better option because you are likely to need all the loan proceeds at once.
If you intend to use your home equity in order to have funds liquid for an emergency or to pay recurring expenses such as college tuition, a HELOC may be a better option.
After changes to mortgage lending regulations, many lenders stopped offering traditional, lump-sum second mortgages (home equity loans), but instead offer the opportunity to "break off" a portion of a line of credit into a fixed-rate, fixed repayment term within the context of the line of credit. This allows borrowers to have a home equity loan if that's what they prefer.
Home equity loans and debt consolidation
While a home equity loan and line of credit typically offer lower interest rates than credit cards, so consolidating higher-rate debt into a lower cost option can be a smart moved. However, you should carefully consider the consequences of borrowing against your home. If you cannot repay the loan, you risk a foreclosure. Another common problem is that you might not be a good manager of money, and might be tempted to take on additional debt after the original credit card debt has been consolidated.
It's also the case that home equity debt is no longer tax favored for most uses. Only interest on home equity debt used to "buy, build or substantially improve" your home is tax deductible. When using these funds for any other purpose (such as debt consolidation, funding college, etc.) the terms may be more favorable than other kinds of loans but the interest you pay can't be deducted from your tax bill.
Careful evaluation of your goals and the repayment plan can help you make the right choice between a home equity loan and a HELOC.
Related: Home Equity Calculator and Projector
