Home-Equity Loans: The Costs
A home-equity loan can be a good tool for savvy homeowners looking for a convenient way to borrow money. Many home-equity loans offer an attractive interest rate (compared to those offered by credit cards and other types of loans), and borrowers can deduct the interest when they file taxes. But not all home-equity loans are alike. Getting a loan that offers competitive rates, fees and terms takes a little extra effort. Here are a few items to keep in mind when you start shopping for a home-equity loan.
Before you go shopping for a loan, remember leveraging your home for cash is a big decision. Make sure you know the different types of home-equity loans as well as the factors that determine whether it's a sound financial decision. (To learn more, see The Home-Equity Loan: What It Is And How It Works, To Rent or Buy? The Financial Issues - Part 1 and Mortgages: How Much Can You Afford?.)
First, Take a Look at the Largest Costs
The single largest cost associated with most home-equity loans is interest. When comparing loans, keep in mind that the annual percentage rate (APR) is calculated differently on a traditional home-equity loan than on a home-equity line of credit - the first has a fixed interest rate and the second has a variable interest rate. The APR for a home-equity line of credit is calculated based on the loan's interest rate. The APR for a traditional home-equity loan generally includes the costs of initiating the loan. Because of this difference, a direct comparison between fixed-rate loans and variable-rate loans cannot be made.
Regardless of the type of loan, the expense incurred by paying interest provides you with a powerful incentive to pay off the loan early. Keep in mind, however, that both traditional home-equity loans and home-equity lines of credit may charge a fee if you pay off the debt before the agreed date.
Second, Check out those Hidden Fees
Interest is the largest single cost associated with most equity loans, but it is not the only expense borrowers face. Taking out a home-equity loan or a home-equity line of credit imposes the same fees as a mortgage. These fees include closing costs such as attorney fees, title search, document preparation, and insurance. They also include an appraisal to determine the market value of the property, an application fee for processing the loan, points (one point is equal to 1% of the loan) and an annual maintenance fee.
If you choose a home-equity line of credit, you may be required to pay a transaction fee each time you make a withdrawal, and an inactivity fee if you don't use your line of credit over a given period. When comparing fees of different loans, keep in mind that some lenders will waive closing costs and other fees, so be sure to ask for a waiver. (To learn more, see A Tax Primer For Homeowners, Mortgage Points - What's The Point?and The Mortgage Interest Tax Deduction.)
Third, Do your Shopping...Smartly
Any time you're shopping for a loan, be sure to compare the programs offered by a variety of lenders. Your local bank may have a perfect loan for your needs, but don't overlook the programs offered by credit unions. Many credit unions are easy and free to join and offer home-equity loans with lower fees and interest rates.
The internet is a convenient marketplace that enables borrowers to quickly compare the loans from multiple vendors. You can surf the web any time of the day or night and get instant access to loan providers from across the country. Even if you prefer to conduct transactions face-to-face, online shopping can provide information to help you negotiate the best deal and may help you find a loan provider nearby.
Once you've identified a competitive loan program, it's time to ask questions. While you may have been attracted to a particular program based on its low interest rate or origination fees, it is important to pay attention to all the details and factor in the total cost of the loan rather than focusing on a single feature.
Talk to the lender about pre-payment options. Ask if there is a penalty for retiring the loan early, and make sure you understand the repayment schedule. Ask also if the loan is structured with a balloon payment, which requires a full repayment of any outstanding balance at the end of the loan term - if your repayment schedule caused you to repay only a small amount of the principal over the term of the loan, this balloon payment could be more than you can handle. If you take a home-equity line of credit, ask about the cap on the interest rate and find out how high the payment can go before the cap applies.
Finally, Choose Wisely
Because you are using your home as collateral, it is particularly important that you consider carefully all elements of any home-equity loan before taking it. Borrowing against your house puts you at risk of foreclosure should you be unable to repay the debt, so make sure you understand what you're getting into and that you can afford to repay the loan before or when its term ends.