Types of Home Equity Loans

Fundamentally, there are two types of home equity loans.

• Home Equity Line: When you get a home equity line, you obtain the right to draw money, whenever you want, over a certain period of time. You only pay interest on the amount you borrow. You may borrow, pay off and borrow again against the line of credit. You typically access the line with a check or credit card.
• Second Mortgage (home equity loan): When you get a second mortgage, you obtain a lump sum of money. The interest rate and monthly payments are fixed.

Before deciding which type of loan you want, consider how you'll use the money. If you need funds for a single expense, such as a room addition, remodeling, etc., you'll want to strongly consider a fixed-rate, second mortgage. You receive one lump sum at the beginning of the loan term. You pay it back in equal, monthly installments.

The certainty of a fixed interest rate and equal monthly payments make the fixed-rate, second loan very attractive. Will this type of loan be less expensive compared to an adjustable rate, home equity line? There is no way to know with certainty. One would have to be able to predict interest rates with accuracy. Consider one of the reasons why adjustable rate loans were invented:  to shift interest rate risk from the lender to the borrower. When market interest rates rise above the interest rate on your fixed-rate mortgage, the lender is effectively losing money on your mortgage and you're getting a bargain. Lenders wanted a way to protect themselves from this situation--thus the adjustable-rate mortgage. 

If you need periodic amounts of money over time, for a child's education tuition, for example, a home equity line may be ideal. You can borrow only the amount you need, when you need it. These loans carry adjustable (ARM) rates, but some banks allow you to convert a portion of your loan to a fixed-rate second. You may pay a premium for the convenience of an equity line, including a transaction fee for each draw and an annual fee if you draw or not. 

Deciding in advance which type of loan is best for you helps when comparing the expense of various loans. Since the APR for a fixed-rate second is calculated differently compared to a home equity line, APR comparisons can be difficult when comparing a fixed-rate second to a home equity line. APRs of fixed-rate seconds account for points and other closing charges.  APRs for home equity lines don't account for points and other closing costs. When comparing the same types of loans (apples to apples), APRs are much more meaningful.

*  Interest may be fully deductible. Consult your tax advisor regarding your particular situation.
** Under certain circumstances, some loan programs let you convert part of your home equity line to a fixed-rate, home equity loan.