Home equity loan or Home equity line of credit - which is right for you?

According to the Consumer Bankers Association, home equity loans and home equity lines of credit chalked up a combined growth of 29% in 2003, preceded by the 31% growth rate in 2002.  This reflects that home equity loans and home equity lines of credit have continued to grow in their popularity.  Most likely, you are one of the many people who are deciding to cash in on their home's equity value.  Which of these 2 popular options are right and good for you: home equity loans or home equity lines of credit? To help you decide, we suggest the following 3 principal factors that you should weigh to make an objective decision for yourself.

These 3 principal factors are tied to the difference in the characteristics of home equity loans and home equity lines of credit. These 3 factors are:

• certainty vs flexibility,
• one-time lump-sum cash vs on-demand cash, and 
• forced repayment discipline vs self-imposed repayment discipline.

1.   Certainty vs flexibility -- There is certainty but no flexibility in home equity loans in that you have a fixed repayment schedule, and the equity loan rates are fixed over the fixed lifespan of the loan.  In short, you know exactly when and how much to repay every month, and for how many years to repay. This certainty is useful to you if your income streams are pretty secure in the foreseeable future.  This certainty also benefits you by forcing you to be disciplined in your repayment. Given all these certainty elements, you are able to plan and control your financial affairs. The ability to plan and control your money with discipline is a key factor to your financial success.

You have flexibility and uncertainty in home equity lines of credit.  Your interest rates (APRs or annual percentage rates) change periodically and therefore are uncertain.  However, you have the flexibility in repaying any amount of the loan you like as long as your repayment is not less than the minimum required.

If you are not certain about the regularity and size of your income streams in the foreseeable future, this flexibility of equity lines of credit may be suitable for you because you are subjected to only one fixed element, ie the required minimum repayment amount which you can afford.

The weakness in this flexibility is the lack of forced repayment discipline. Borrowing money and not paying back the lender may lead to you losing your home.

If you take the time and effort to look for an equity line of credit that gives you the option to convert to a home equity loan, you will have an added "flexibility" should a home equity loan become more beneficial to you one day.

2.   One-time lump-sum cash vs on-demand cash -- Home equity loans give you the full amount of loan in one lump sum.  It will suit you if you have a one-time payment need, eg credit card debt consolidation whereby you use the full amount of the cash to pay off your credit card debts at one time, buying a second home, etc.  Your lender starts charging you interest on the full amount of the loan from the day it is handed over to you, regardless of whether you use all of it.

If you are embarking on a multi-year home improvement project for which you will be writing checks at varying intervals, an home equity line of credit may be best because you can draw any amount of cash with a check from your line of credit, as long as you do not burst the approved credit limit.  Also, a home equity line of credit is probably best for paying sporadic college expenses.  You will be charged interest only on the outstanding laon that you have used, and not on the entire approved credit limit (make sure that your line of credit does not charge "non-usage fees").

3.  Forced repayment discipline vs self-imposed repayment discipline -- As pointed out in paragraph #1 above, the fixed repayment schedule of a home equity loan forces repayment discipline on you.  This enhances your ability to plan and control your spending.

By contrast, an equity line of credit lacks the virtue of repayment discipline.  Since an equity line of credit functions very similarly to a credit card, it will end up like a huge credit card debt if you do not manage it with discipline.  You may risk losing your home to the lender.

We recommend that you draw up a fixed repayment schedule for your outstanding loan, thus treating your equity line of credit as if it was a home equity loan. Then exercise self-discipline to adhere to your self-made repayment schedule uncompromisingly to make the monthly repayments.

Because your interest rate will change, and also because your outstanding loan may increase as a result of you drawing additional cash, you will need to periodically revise your fixed repayment schedule.  You can make changes very easily with online mortgage calculators.  Numerous online mortgage lenders provide free, powerful mortgage calculators that enable you to do "what if" analysis so that you can work out as many different repayment schedules as you like, and choose the most suitable one to implement.  Look for their sources on this site.

By being financially disciplined in this way, you can almost have the best of both worlds -- you can enjoy the flexibility of an equity line of credit to borrow cash only as needed, and the certainty of a fixed repayment schedule.  You will also enjoy the other benefits of an equity line of credit, viz. lower fees, initial (introductory) interest rate, and often lenders do not charge points.  A home equity line of credit is also easier for you to qualify.

To compensate for the uncertainty of your interet rate changes, you can ask your equity line of credit lender to provide a periodic cap on the interest rate and the option to convert to a home equity loan.

According to the Consumer Bankers Association 2002 Home Equity Study, home equity lines of credit had a larger market share than home equity loans.  Whether you decide on a home equity loan or a home equity line of credit, be certain to shop for the best deal possible.  Make sure the beneficial features discussed in "Home equity line of credit - 9 benefits you should look for" are integral to your home equity line of credit.

The market is extremely competitive and there are many non-traditional options, including online lenders and credit unions.  Look for their sources on this site.

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