Term loan? Line of credit? Which should you choose?

The two main ways of borrowing against the equity in your home are the revolving line of credit and the term loan. There are good points and bad points to each. Which one would best serve you?

The most commonly issued form of home equity loan is the term loan. Similar to a typical mortgage, the term loan offers a fixed amount of money, at a fixed interest rate, over a fixed length of time. The amount of time may vary, but it typically runs anywhere from five to fifteen years. The value of the loan usually does not exceed 80% of the home’s equity, but some loans, known as High LTV (loan to value) loans, may offer amounts of up to 125% of a home’s equity. Would a term loan suit your needs?

The term loan is best suited for those who have a specific purpose in mind with a specific cost. A good example would be a wedding, debt consolidation of high-interest credit card loans, or a home remodeling job such as a kitchen or bathroom remodel. A loan used for such purposes would give the borrower a fixed payment, every month, for the duration of the loan. Interest rates for home equity loans are quite favorable, and tend to run just a bit higher than the rates for 30 year mortgages. A bonus, of course, is that the interest on a home equity loan of up to $100,000 is fully deductible from Federal income tax. For many borrowers, a term loan is a good choice, especially since the repayment terms are known and fixed.

A newer alternative to the term loan, and an increasingly popular one, is the home equity line of credit. This type of loan works rather like a credit card account, in that the amount of the loan represents the maximum amount of money that the homeowner may borrow at any one time. The money is borrowed against the balance using either checks or a debit card and payments are only required when money is actually used. Suppose that the loan amount is $10,000. The borrower may borrow the entire $10,000 at once, or $1000 here and $1000 there as needed, or the borrower may simply put the loan documents away just in case the money is needed for an emergency. Lines of credit are ideal for “rainy day” situations, as the money can be drawn against the loan as needed. Unlike a term loan, the interest rate on a line of credit is adjustable and will adjust with prevailing market conditions. The interest remains deductible from income tax returns.

A line of credit is best suited for expenses that recur - an ongoing educational expense or a home remodeling project by a do-it-yourself type that may be open-ended in nature.

Each type of loan has its advantages and disadvantages, and what works best for one homeowner may not work well for another. Each borrower should discuss his or her needs with their lender, who can assist in helping the homeowner make the best decision for their needs. Either type of loan will work well for a variety of uses.