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Home Equity Loans: How to Choose Them, How to Use Them

By Gina Pogol
Mortgage Credit Problems Columnist


Homeowners take home equity loans or lines of credit for a variety of reasons. And some loans are better suited for certain purposes than others. Home equity loans and lines of credit carry different terms, so before you take on a second mortgage, you should consider your options.

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Home equity loans are often called second mortgages because the lender only gets paid after the holder of your first mortgage if you default. Because of this added risk, interest rates on home equity loans are higher than those of first mortgages.

Home Equity Loans

Traditional home equity loans allow you to borrow a lump sum and repay it in regular monthly installments. The interest rate can be fixed or variable. Because you pay interest on the entire amount from day one, these loans are best for taking care of large expenses like medical emergencies, debt consolidation, or second home purchases.

Using a second mortgage to consolidate unsecured debt like medical bills or credit cards gets you the lowest rate and payment on those debts, but it means that you can no longer discharge them in bankruptcy should financial disaster strike. Often, home equity loans are amortized over 30 years, but their terms are only 15 years, so you may have a balloon payment or need to refinance.

  • Pros: Fixed rate and payment makes budgeting easier and interest rates are generally lower. If your home's value declines, your loan cannot be called or your proceeds reduced.
  • Cons: You must accept and pay interest on the entire amount from day one. If you need more money, you must take out another loan.

Home Equity Lines of Credit (HELOCs)

Home equity lines of credit, or HELOCs, offer flexibility. Once you are approved for a credit amount, you can use, pay, and reuse it. You may be issued checks or a credit card to draw on your credit. This flexibility makes the HELOC ideal for paying annual college tuition, funding a renovation over time, or providing emergency cash flow for a business. HELOC interest is typically variable, but many lenders give you the opportunity to convert all or part of your balance to a fixed rate at one or more times over the life of your loan.

  • Pros: You only pay interest on the amount of credit used. You have the flexibility to use and reuse your credit.
  • Cons: Variable interest rates are riskier than fixed rates. Your credit line can be reduced if your home's value drops.

Costs of Second Mortgages

Home equity loans and HELOCs come with higher rates than first mortgages, but their costs are quite low. Some lenders even waive the fees altogether. To find the best home equity loan with the most favorable terms, complete the form on this site. HELOCs may come with prepayment penalties; read your documents thoroughly before committing to a loan.

Sources

http://www.wsj.com / http://www.federalreserve.gov

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