The home equity loan
A conventional home equity loan, also known as a closed-end home equity loan or fixed rate mortgage, allows individuals to borrow a one-time lump sum amount. They can also make repayments over a set time frame. Some lenders may require their customers to pay in a span of six months, while some lenders allow their customers a leeway of up to twenty years. Typically, the norm for repayment periods for these types of loans is 15 years. Seventy-five percent of all home mortgages are closed-end home equity loans.
The interest rate on a closed-end loan never changes for the entire duration of the loan, and as such, the individual's monthly payments remain the same no matter how long he or she has been paying it. With this in mind, these types of loans allow borrowers to have better control on their finances. Being aware of how much to pay towards the principal amount and interest payments allows the individual to budget their resources accordingly. A closed-end loan is also meant for an individual who intends to stay in their home for a very long time.
Acquiring a fixed rate mortgage also entails having to pay certain fees and closing costs. Much in the same way that a homeowner pays for certain fees when they obtain property, an individual is also required to pay for certain fees when they need to apply for equity. The fees are applicable towards property appraisal, in order for the lender to estimate the value of the home; application fees, which are not refundable even if the request for loan was not granted; title searching; payment for an attorney or title agent's services; and document preparation. Taken together, the fees comprise at least 2 to 5 percent of the total loan amount. An individual may also be obliged to pay for a prepayment penalty if the account was either paid off or closed within a two to three year duration.
The home equity line of credit
The second type of loan is called a home equity line of credit, or a HELOC. It is also known as an open-end home equity loan and a variable-rate or adjustable-rate mortgage. Unlike a closed-end loan, the HELOC has a revolving balance, much in the same way that a credit card works. An individual can borrow any amount within a set period of time called a draw period. Draw periods usually take five to ten years, but it is the lender's discretion to determine the specific time frame. As long as the customer is within the draw period, he or she can be able to take out a certain amount of funds as needed. This may sound like an enticing idea, but borrowers are not permitted to milk the loan dry of funds, as a HELOC also has a specific credit limit.
As its name implies, an adjustable-rate mortgage has a variable rate, and it can drastically change within the loan duration. The borrower's monthly payments may vary as a result. Other factors that can affect these changes are the principal amount, or the amount borrowed, and whether the loan is currently in the draw period or the repayment period. A debtor is usually given 10 to 15 years to complete the loan repayments, but different lenders also have different rules how long the repayment period will last. While an individual is in the process of repaying his or her loan, they are not allowed to acquire new debt.
If the most common fee that a borrower needs to pay on a home equity loan is the appraisal fee, an individual's biggest expense in terms of getting a line of credit would be the interest payments. Percentage rates will vary for the entire loan duration. A lender may first offer a lower rate, called a teaser rate, to get the ball rolling. Teaser rates are typically lower than the current rate the market offers, and it allows the borrowers to make lower monthly payments at the onset of the repayment period.
The loan's variable rate is dependent on an index, which is the basis on which the interest is computed or calculated. Examples of indices that most lenders follow and adhere to are the US Treasury's notes and bills, as well as the Federal Housing Finance Board's national average mortgage rate. Aside from the index, the lender may also add a margin to the index in order to find out how much the new rate is after adjustments are made.
Also keep in mind that lenders need to inform the borrowers of their interval of adjustment, or the period of time that the percentage rate will change. It is entirely dependent on the creditor as to how often this interval will be set. As a borrower, you also need to be aware of your rate cap, or the highest amount that a percentage rate can increase to in an interval of adjustment. The purpose of a rate cap is to prevent the interest from going over and beyond two percentage points in one year. Your payment cap, on the other hand, is the maximum amount the debtor's payment can go up in each interval.
Aside from these percentages, HELOC's have other fees attached to them. These include annual maintenance charges, transaction fees that are charged each time the account is used, and inactivity fees if the account is not used for a certain time period. And much like its counterpart, pre-terminating the loan agreement or doing an early payoff on a HELOC may also require the borrower to pay a pre-payment penalty.
Comparison and contrast
A few downsides to choosing a fixed-rate mortgage include having higher interest rates compared to loans that have involve revolving credit. Creditors have set this figure accordingly, due to the higher risk involved in lending money. They also have less flexibility than HELOC's do. Also, a borrower's repayment amounts towards this particular loan are higher compared to an adjustable-rate mortgage.
The best uses for a home equity loan are for expenses that require an individual to make one-time, lump-sum payments, such as consolidating unsecured debt and making home repairs and improvements. On the other hand, using a HELOC allows the borrower to borrow any amount of money at any time needed.
Repaying a HEL and a HELOC is also vastly different. An individual is required to pay principal and interest towards the former. The payments need to be made every month for the entire repayment period. In contrast, the customer has the option of paying for just the interest in a HELOC. That might turn out to be a bad idea in hindsight, as you may not be lowering the principal at all the whole time that you were paying for the loan.
Read these related articles:
Why home equity loans make sense
Am I qualified for a home equity loan
How is home equity calculated