Second mortgage or line of credit?
Rising home prices, coupled with increased incomes, have provided consumers with more household wealth and equity in their homes. Some have used the additional income to pay down their mortgages faster.
In a capsule, more homeowners have emerged from being underwater on their loans and many are now breathing comfortably above the surface.
How many? Several reports have tried to estimate the number. CoreLogic reported that for the first nine months of 2012, about 1.4 million borrowers moved above water. Zillow recently estimated that 2 million homeowners last year emerged from being underwater. And J.P. Morgan Securities reported that the number of underwater homeowners fell from 11 million to 7 million last year.
Lenders have anticipated the turnaround and are again offering low-cost home equity loans to borrowers who had to put their needs and wants on hold during the economic downturn. If you have a home remodeling job that’s been on the backburner or a tuition bill about ready to eclipse your savings account, you’ve probably thought about a home equity loan. Make sure you understand the difference between programs and how home equity funds are dispersed.
There are two types of home equity loans — the conventional second mortgage and the home equity line of credit (HELOC). A second mortgage provides you with a lump sum of money repayable over a fixed period of time while a HELOC gives you a credit line you can tap into whenever you wish.
Here are some differences.
A HELOC is more flexible. With a line of credit, the borrower can tap into the fund whenever she needs. If you plan to use the money for recurring debt, such as medical bills, tuition payments or a rather large home improvement project, a HELOC is usually the better choice.
A second mortgage is more predictable and conservative: If you are naturally conservative and like the idea of knowing you have borrowed a specific amount of money and will pay it back in specific amounts each month for set number of years, then a second mortgage might be a better option for you.
Second mortgages are usually fixed rates; equity line rates adjust. One of the biggest negatives with second mortgages when compared to HELOCs is that second mortgages usually come with an interest rate higher than a home equity line of credit. That’s because second mortgages come with fixed rates while equity lines offer lower initial rates in exchange for the borrower assuming the risk of a changing market. If market rates rise, so does the rate on the HELOC. HELOCs typically adjust monthly or quarterly.
Second mortgages offer less temptation. Second mortgages do not allow a borrower to pay down, and then retap into a seemingly endless pool of credit, thereby reducing the tendency to overspend and stretch out the repayment. With a HELOC, borrowers often purchase items they don’t really need and often regret buying when it’s time to repay the debt.
If you plan to use the money to set up a new business, buy an investment property or loan a sibling a lump sum for an emergency, financial experts say a conventional second mortgage is probably the better way to proceed. It’s wise to double check the amount needed because applying for additional funds later can be expensive and problematic.
If you plan to use the money to pay for mom’s periodic medical bills, your child’s tuition payments or a wedding, a HELOC is usually the better choice. Again, the HELOC allows you to tap into a credit line only when you need it.
Before entering into any home equity loan, be honest about how you spend and repay your debts. If you have a history of maxing out credit cards, will you max out your credit line and then be stuck with no other way to repay it?
Make sure any second mortgage goes toward a special project or event. You do not want to be paying for a shopping spree with money from the roof over your head.
Tom Kelly, former real estate editor for The Seattle Times, is a syndicated columnist and talk-show host.
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