Buying a home is a huge investment that is generally financed by a first mortgage. The need for a second mortgage generally arises when one is forced to spend on repairs pertaining to the house.
Sometimes, a second mortgage helps to pay for a child's education, consolidate credit card debts, buy a car, pay for medical expenses, and meet other unavoidable financial commitments. In case of a second mortgage, the collateral is the home, and thus, the second mortgage provider's claim on the asset (home) is subordinate to the first mortgage provider.
Since the rate of interest paid on a mortgage is based on the risk of default, a second mortgage carries a higher interest rate as compared to the first. Second mortgages are of two types: Home Equity Loans (HEL) and Home Equity Lines of Credit (HELOC).
Home Equity Loan (HEL) or Home Equity Line of Credit (HELOC)?
Which is better: HELOC or HEL? This is a problem that confronts most people who desire to borrow against their home equity. The choice of home equity debt depends on the following factors:
People are generally confused about the kind of home equity debt that should be sought, since both HELOC and HEL are home equity debts. The choice of a home equity debt depends on the purpose for which we intend to use it.
When the money is required all at once for major one-time expenses, like buying a car or consolidating debts, HEL is preferred. In case of recurring expenses like home repairs, medical bills, and education, HELOC is a better option.
HEL is a lump sum payment made to the borrower. The borrower in turn is expected to pay interest and principal payments on a monthly basis. The interest payments may be tax deductible. In case of HELOC, during the 'interest only' period a person is required to pay an interest on the amount of money he uses from the loan that is sanctioned.
In other words, HELOC is like a credit card that allows you to withdraw an amount as and when required. If you are confident about the time and the amount of financial commitments, HEL would be a better option.
Rate of Interest
The rate of interest on HEL is fixed. Thus, it is desirable if the interest rates are expected to increase in future, since one would still make payments on the lower rate of interest. It is meant for people who have a regular income and can allot a chunk of their salary to monthly payments.
HELCO on the other hand has a variable interest rate structure and interest on withdrawals are calculated using the APR (Annual Percentage Rate). The APR is based on the prime lending rate, which in turn depends on the Federal Funds Rate. If the prime lending rate increases, we would have to make higher interest payments.
Duration or Maturity of the Debt
A home equity loan can be obtained for a period of 5 to 30 years. Since the loan has an amortization schedule, one makes both principal and interest payments. The interest is calculated on the principal balance remaining at the end of each month. At the end of the maturity period, there is no remaining balance since the loan would have been paid off in full.
Generally, in case of HELOC, one has the option to withdraw money on a regular basis for a period of 10 years. At the end of this period, any remaining balance on the debt gets converted to a loan with a maturity of 15 or 30 years. It might be a good option to go for HEL if one feels that HELOC might stretch out the payments.
Impact on Credit Scores
HELCO has a greater negative impact on the FICO score as compared to HEL, since the former has a revolving credit card structure. Moreover, HEL indicates the ability to meet fixed payments. So in case of low credit scores, HEL would be a better option.
Ultimately, the amount of home equity debt that a person can access depends on the amount of equity that has been built on the house. Home equity, which is the difference between the market value of the house and the remaining mortgage balance, is the determining factor when it comes to seeking a second mortgage.