Home Equity Loans - Types of Loans

There are two main types of home equity borrowing instruments. These are fixed rate (also known as closed-end) loans and lines of credit. Both these instruments are sometimes referred to as second mortgages. They are typically of a shorter duration than your first mortgage; the typical term of home equity instruments is 15 years.

• Fixed Rate Loans: These are loans in which you are given a lump-sum by your lender and are then given a fixed term and fixed monthly payments with which to pay it off. You cannot borrow more money than was disbursed originally. Monthly payments are a combination of interest and principal and amortize over the life of the loan. In structure, these are very similar to mortgages. The interest rate is fixed over the life of the loan.
• Home Equity Lines of Credit (HELOC): These loans are more similar to credit cards. You are authorized to borrow a certain amount for the life of the loan. At the end of the term, the full amount is due back. The main difference between this and the home equity term loan is that the interest rate is variable and you get more flexibility. For example, if have a $10,000 HELOC, you borrow $5,000 and pay back $3,000. At this stage, you can now borrow up to $8,000. This is not the case with a fixed-rate home equity loan where the amount you could borrow is fixed at $10,000 regardless of your repayment profile.

Home Equity Loans - Which Type is Right for You?

As with any investment question, there is no clear cut answer to this question. It always depends on your particular circumstances. In general, if you know the amount you need and it is unlikely to change, then a fixed-rate home equity loan is typically what will work best. If however, you are looking at unpredictable amounts over time (for example a home improvement project), then a HELOC may be a better bet.

The single largest use of any form of home equity borrowing is to pay off credit card debt and replace it with low interest rate home equity instruments.