Using Equity to Secure a Loan: Home Equity Line of Credit vs. Traditional Second Mortgage

Homeowners in need of financing for education, medical bills, renovations or other investments often consider using their home as collateral in securing credit. Two ways to do this are secured lines of credit and traditional second mortgages.

Home Equity Line of Credit Defined

A home equity line of credit is a revolving credit account secured against the homeowner’s property. The lender uses a formula to determine how much credit they can extend to the homeowner, often by taking a percentage of the home’s value and subtracting the amount still owing on the mortgage.

Applicants usually undergo a credit check and must show proof of income, assets and liabilities to prove to the lender their ability to repay the loan. Home equity lines of credit usually have an end date, at which time the borrower might apply for a loan renewal.

Tricks and Traps to Avoid When Securing a Home Equity Line of Credit

While most lenders don’t intend to dupe borrowers, there can be hidden fees and conditions involved with a home equity line of credit. It is up to the borrower to read the fine print and ensure they understand all of the terms of the loan before borrowing. Watch for these tricks and traps:

  1. An introductory interest rate- Understand how the interest rates work over the term of the loan. An introductory rate may be attractively low, but could increase six months or a year into the term. Also watch for differing interest rates on different types of transactions, ie.: purchases vs. cash advances.
  2. Penalties for late payments- No one plans on missing a minimum payment, but it is important to understand what will happen if this occurs. Could interest rates increase? Could the account be frozen?
  3. Costs to set up the account- Watch for closing costs, home appraisal fees, application fees, and other expenses that could increase the overall cost of borrowing. Compare the cost of borrowing among several different lenders.

The Traditional Second Mortgage Defined

Where the home equity line of credit is a revolving account, a traditional second mortgage is a fixed-term loan of a specific amount of money, secured against the value of the home. The monthly or bi-weekly payments are usually the same amount over the term of repayment, compared to line of credit minimum payments which fluctuate depending on the amount owing at any given time.

A second mortgage might be the right choice for a homeowner in need of a predetermined amount of money upfront, whereas a home equity line of credit allows for more flexible borrowing. Borrowers should know before securing the loan exactly how they plan to make the payments each month. If they were laid off, could they still make the payments? Would it be manageable if they were off sick for two weeks?

Loan Repayment Tips

Having a plan to repay any debt is crucial in deciding if one can afford to borrow. Even when a lender has pre-approved a certain amount, it is up to the borrower to stop and think, “What is the worst thing that could happen… and if it did, could I still afford these payments?”

It is important for anyone with a loan secured against their home to have disability insurance. Many have life insurance, but fail to pay the extra monthly premium for a policy that would allow them to take care of their responsibilities if they become disabled or sick.

Ensure the loan has flexible repayment terms. Most lines of credit allow the borrower to make larger payments when they are able. However, second mortgages may not. Make sure the terms include flexible repayment terms, including the ability to make lump sum payments or increase monthly payments when possible.