Home Equity Loan vs. Home Equity Line of Credit
For many households in America, the equity built in their home is one of their largest assets on their balance sheets. Historically, this asset has provided growth in value, as well as an opportunity to obtain a secured loan from a bank for short-term or long-term needs. When a homeowner borrows money secured by their home, the homeowner can establish one of two types of loans: a Home Equity Loan or a Home Equity Line of Credit (HELOC).
Generally, a Home Equity Loan can be thought of in a concept similar to a homeowner’s first mortgage. The loan typically distributes a lump sum of assets and the homeowner then makes payments back to the bank based on a fixed rate, a fixed term, and fixed payments.
Alternatively, a HELOC is based on variable payments (with a minimum payment each month), a variable term, and a variable interest rate. Generally, once approved, a homeowner can establish a HELOC which subsequently functions as if the homeowner has the funds in their bank account. This typically allows the homeowner to use debit card functionalities, write a check, or withdraw funds from an ATM.
Most bankers will advise their clients to access a Home Equity Loan when funding a purchase that may require many years to payback – such as an improvement to the home, a wedding, or perhaps even debt consolidation. Alternatively, a HELOC may be advised when someone needs a small amount of assets to help cover a short-term cost such as a monthly float if emergency funds are exhausted or a short-term project which can be paid for in only a few months of household cash flow.
At Ballast, we try to think outside the box and use tools such as these to help our clients advance in planning for their future. Below is one strategy that we have helped a client implement and it worked well for them. This strategy is not for everyone and we certainly recommend you contact us prior to trying to implement this strategy. There are also outside factors to consider that are not discussed in this article.
A client of our firm was looking to purchase a new home. The new home was valued at $500,000 and the client currently had $75,000 in equity in their current home. The client was 45 years old, wanted to be debt-free by 70, and wanted to keep his monthly payment at or below $3,400/month. The client had the following options assuming a new loan is established in November of 2017:
1) $425,000 – 30 Year Loan: $2,989/Month – Paid Off November 2047
- $500 taxes, $167 insurance, $156 PMI, $2,166 P&I
2) $425,000 – 15 Year Loan: $3,788/Month – Paid Off November 2032
- $500 taxes, $167 insurance, $156 PMI, $2,966 P&I
3) Total Combined Monthly Payment: $2,679/Month
3a) $340,000 30-Year 1st Mortgage (80% Loan): $2,249/Month – Paid Off November 2047
- $500 taxes, $167 insurance, $1,582 P&I
3b) $85,000 30-Year 2nd Mortgage (20% Loan): $430/Month– Paid Off November 2047
- $430 P&I
For calculation purposes, let’s assume all loan options were created in November of 2017. In the scenarios above, if we established a monthly payment of $3,400/month with extra payment going to principal, below are the results:
1) The 30-year mortgage would be paid off in September of 2039, assuming an extra payment of $411/month and a total payment of $3,400/month.
2) The 15-year mortgage would be paid off in November of 2032. This saves almost seven years or mortgage payments. However, the mortgage payment is $388/month above the client’s goal, which could create cash flow challenges in the future.
3) The Second Mortgage would be paid off in February of 2025 (paying an extra $721/month). Assuming the full second mortgage payment was then subsequently used to pay down the primary mortgage, the primary mortgage would be paid off in January of 2038.
After evaluating all the options, the client chose to obtain both a primary mortgage and a secondary mortgage. The client felt that using this strategy accomplished the following:
- First and most importantly, the client made a personal goal to have the second mortgage paid off within three years, even though the strategy shows a five-year payoff. The idea of a second mortgage made the client have a sense of urgency to pay off the second mortgage. Without the “debt-payoff-goal” of the second mortgage, this client in particular would not have actively sought after making extra payments.
- Second, this afforded the client future flexibility of a lower payment, if required. Immediately, the two loan payments are $310/month cheaper. Once the second mortgage is paid off, the 30-year mortgage payment in option 3 will be $740 cheaper than the 30-year payment in option 1. If their future personal financial scenario required less outflow to their mortgage, there will be an opportunity to lighten the burden once the second mortgage is paid off.
- The client immediately avoided having to pay Private Mortgage Insurance, since their primary mortgage debt was less than 80% Loan-to-Value Ratio. While this may be temporary, it is an immediate benefit.
This strategy is one that helped a client achieve their goals, while providing an opportunity for future flexibility. It may not work for everyone; however, we believe critically thinking outside the box helps clients achieve their goals. We aim to think this way for all clients during every scenario we help consult with.
*This example is for illustrative purposes only. Several additional aspects should be considered when making this analysis. This is not a comprehensive analysis – the numbers are for illustrative purposes only.