As an investor, it’s in your best interest to familiarize yourself with the loan options you have at your disposal; only then will you truly be able to maximize your profits on a given deal. However, there are probably more options made available to you than you may realize. Countless loans with variable rates and terms are around every corner, and the more you know about them, the better.
While there are many different loan types I have come to rely on over the course of my career, there are two I want to specifically address today: HELOCs and the popular home equity loan. To better understand the differences that exist between a HELOC and a home equity loan, let us first define the parameters of each:
Home Equity Loan (HEL)
As Investopedia so eloquently puts it, a home equity loan is a “consumer loan secured by a second mortgage.” The homeowners that go down this path are awarded the opportunity to borrow a fixed amount against the equity they have managed to create in their current residence. That said, the average home equity loan is based on the difference that exists between said homeowner’s equity position and the current market value of the home in question. The money is given to borrowers in one lump sum, and is typically accompanied by a fixed interest rate, fixed term and fixed monthly payment.
It’s worth noting that a home equity loan resembles something we are all too familiar with: a line of credit. However, unlike your standard credit card, a home equity loan is secured by the subject property. “When the line of credit is drawn down, the financial institution providing it places a second mortgage loan on your home until the loan is paid off, after which the you can use the loan to finance other purchases,” says Investopedia. That said, acquiring a home-equity loan is not without it’s caveats: neglecting to pay off the loan in the predetermined window could result in the loss of your home. The lender has the right to sell the property in the event you fail to meet your mortgage obligations. So will there is certainly a time and a place to secure a home-equity loan, it’s in your best interest to weight the costs and benefits.
Home Equity Line of Credit (HELOC)
Not unlike their home-equity loan counterparts, HELOCs use the borrower’s home as collateral. However, instead of receiving the money in one lump sum, HELOCs extend a line of revolving credit to the borrower; they can borrow the money as they need it. The amount of credit borrowers may receive is based on “a percentage of their home’s appraised value and subtracting the balance owed on the existing mortgage,” according to Discover. Interest, on the other hand, is accrued through he assistance of a predetermined variable rate; typically the prevailing prime rates at the time the loan was issued. The duration of HELOCs can range from less than five years to more than 20, but no matter the time frame, all balances must be paid in full or you run the risk of losing your home as collateral.
It’s worth noting that after the borrower has been given the line of credit, they may draw from it at their own discretion with relative ease, as the lender will typically offer special checks or a credit card tied to the HELOC account. Not all HELOCs are created equal, however. Be sure to confirm the guidelines of your HELOC, as some will require the borrower to “withdrawal” a minimum amount each time. Check with your lender to make sure you understand what will be required of you.
On the surface, HELOCs and HELs have a lot in common. However, there are subtle yet important differences worth noting, not the least of which are respective interest rates and payment methods.
First things first; whereas your standard home-equity loan typically coincides with a fixed interest rate, HELOCs have become synonymous with variable rates. It’s worth noting that there are exceptions to the interest rate policies, but HELOCs and home-equity loans are typically associated with variable and fixed rates respectively.
Outside of the interest rate policies regarding each, the manner in which HELOCs and home-equity loans are paid off exhibit subtle differences of their own. Again, there are exceptions, but home-equity loans typically follow a structured pay plan. More often than not, they are paid back with a monthly fixed amount; accounting for both principle and interest payments with each reoccurrence. HELOCs, on the other hand, are typically subjected to shifts in interest payments. “Once there is a balance owing on the loan, the homeowner can choose the repayment schedule as long as minimum interest payments are made monthly,” according to Investopedia.
I can say with the utmost confidence that there is a time and a place for each of these loan options. However, the single most important determining factor when deciding between the two is your reason for borrowing. Only once you have an idea of what you want to do with the money can I recommend choosing between HELOCs and the popular home equity loan.
I maintain that large, one-time payments are better reserved for home equity loans. If for nothing else, a home equity loan will allow you to pay for any expenses without the temptation of available credit burning a hole in your pocket. It’s also not a bad idea to use a home equity loan to consolidate debt.
Those that expect reoccurring payment expenses, on the other hand, may want to consider HELOCs, as they conform to a more “pay as you go” approach. It’s worth noting that HELOCs only charge borrowers on the amounts drawn against their credit line, meaning you can spend it on multiple, smaller transactions over the duration of the loan, as opposed to borrowing the full amount and paying interest beforehand. What’s more, HELOCs provide borrowers with more flexibility, as they won’t have to pay until funds are drawn from the credit line.