HELOC or fixed home equity loan? What’s best for you?
The pros and cons of HELOCs and HELOANs
The home equity loan, or HELOAN, and the home equity line of credit (HELOC) both offer the opportunity to exchange some of your home equity for cash. But which product is best for you?
The answer depends on the reason for borrowing.Verify your new rate (Oct 19th, 2019)
What is a HELOAN?
Home equity loans are (usually) fixed-rate products, which means the interest rate and monthly payment don’t change.
They are fully-amortizing, which means you pay the loan in full over its term with regular monthly payments. The loan proceeds are dispensed in a lump sum when you close your loan.
HELOANs are more expensive to set up, requiring many of the same fees and processes as a traditional refinance.Verify your new rate (Oct 19th, 2019)
What is a HELOC?
HELOCs are credit lines with (usually) variable rates. Your monthly payment depends on your current interest rate and loan balance.
These loans are essentially revolving accounts, similar to credit cards. You can draw any amount, up to your limit. You’re allowed to pay it down or off at will.
HELOCs have two phases. During the draw period, you use the line of credit all you want, and your minimum payment covers just the interest due.
Eventually, the HELOC draw period ends, and your loan enters the repayment phase. At this point, you can no longer draw funds and the loan becomes fully amortized over its remaining years.
HELOC payments can increase sharply once the drawing period is over and the repayment phase begins.
Why choose a home equity loan?
The home equity loan delivers a lump sum at closing. It’s appropriate when you want a larger sum of money, you know how much you want, and you plan to spend it quickly.
Here are some appropriate uses for a HELOAN:
- Debt consolidation
- Down payment on a second home or investment property
- Pay a builder for a home addition
- Funding a large investment
Home equity loan closing costs are higher than those of HELOCs. It may not make sense to incur these costs if you plan to borrow a small amount and pay it off fast.
Why pick a HELOC?
The chief benefit of the HELOC is its flexibility and low closing costs. Its biggest disadvantage is its variable interest rate, which can decrease or increase during the loan’s term.
Homeowners who choose HELOCs may want to borrow less money. They may not know exactly how much they need. And they might want to withdraw their funds over time instead of upfront.
Examples of appropriate uses of a HELOC include:
- Credit for your business
- Pay college tuition each semester
- Fund an ongoing home improvement project in stages
- Credit for emergencies
“Convertible” HELOCs allow you to lock in a fixed rate at one or more times during their terms. You may want this option to stabilize your payment.
Another option: a convertible HELOC
Convertible HELOCs are lines of credit with an additional feature—the conversion option.
What this means is that at some point during the loan’s lifetime, you get the opportunity to convert your HELOC to a fixed rate, fully amortizing second mortgage.
- Some lenders allow you to convert your HELOC balance to a fixed-rate loan when the draw period ends and the repayment period begins.
- Others give you more than one opportunity. You can convert existing balances to fixed-rate financing any time during your loan’s life.
- Your new fixed rate is generally the prevailing fixed rate for that loan term, plus a premium for the conversion.
- The new rate may not be a bargain. One homeowner who was paying under four percent with a variable rate loan found that converting her loan would get her a nine percent fixed rate.
- Some convertible HELOCs extend your repayment. For instance, you could start with a 25-year HELOC with a 15-year draw period. When the draw period ends, you might be able to convert your remaining balance to a 30-year fixed loan.
If you already have a HELOC, check your paperwork. Your loan may allow you to convert to a fixed rate. Note that there may be fees involved.
When shopping for a HELOC with a conversion option, ask lenders these questions:
- Is there a charge for the conversion? If so, how much is it?
- Will I be able to use the remaining credit available on the line after a conversion?
- Does the loan convert to a new fixed loan (for example, with a 30-year term), or is the balance amortized over the remaining term of the existing loan?
- How many times can I convert?
- How often can I convert?
- What determines the new fixed interest rate?
See what the loan’s fixed rate would be if you were converting it now. You might not find the conversion option worth exercising if the rate would be too high.
Understand that if you’re not prepared, your HELOC could become unaffordable during its repayment period.
If you borrow for 25 years, max out your credit during the 10-year drawing phase, and have just 15 years to repay it in the repayment phase, you could find yourself in over your head.
That goes double if your interest rate has increased during the loan’s term.
Before borrowing, understand what could happen to your interest rate and payment.
Have a repayment plan that includes provisions for higher interest rates, and determine how much you can afford to be carrying when the repayment phase starts.
What are today’s mortgage rates?
Current mortgage rates depend on the product you choose. In the case of the HELOC, these rates are variable.
Variable rates protect lenders from inflation, which allows them to offer a lower start rate.
Fixed-rate HELOANs begin with higher rates, but there is no risk of your rate and payment increasing.Verify your new rate (Oct 19th, 2019)