Getting a Home-Equity Loan

1. Not checking to see if your loan has a pre-payment penalty clause.

If you are getting a "NO FEE" home-equity loan, chances are that it has a hefty pre-payment penalty clause. This can be very important if you are planning to sell your house or refinance in the next 3-5 years.

2. Getting too large a credit line.

When you get too large a credit line, you can get turned down for other loans, because some lenders calculate your payments based on the available credit and not just the used credit. Having a large equity line indicates a large potential payment, which makes it difficult to qualify for loans. Note: this argument holds even if your equity line has a zero balance.

3. Not understanding the difference between an equity loan and an equity line.

An equity loan is closed - i.e., you get all your money up front and then make fixed payments on that loan, until you pay it off. An equity line is open - i.e., you can get an initial advance against the line and then reuse the line as often as you want during the period that the line is open. Most equity lines are accessed through a checkbook or a credit card. On equity lines, you only pay interest on the outstanding balance.

Use an equity loan when you need all the money up front - e.g.,, home improvement, debt consolidation.

Use an equity line if you have an ongoing need for money or need the money for a future event e.g. you need to pay for your child's college tuition in 3 years.

4. Not checking the lifecap on your equity line.

Many credit lines have lifecaps of 18%. Be prepared to pay payments at higher interest levels if rates move upwards.

5. Getting a home-equity loan from your local bank without shopping around.

Many consumers get their equity line from the bank that they have a checking account with. Use your bank, but shop around first.

6. Not getting a good-faith estimate of closing costs.

Your mortgage company is required to provide you with a written good-faith estimate of closing costs within 3 working days of receiving the application.

7. Assuming that your home-equity loan is tax deductible.

In some instances, your home-equity loan is NOT tax deductible. Perhaps you make too much and fall into the alternative minimum tax trap, or perhaps you have pulled out more than $100,000 cash from your home. Do not depend on your mortgage company for information regarding this matter - check with an accountant or CPA.

8. Assuming that a home-equity loan is always cheaper than a car loan or a credit card.

A credit card at 6.9% is cheaper than a credit line at 12% even after the tax deduction. To compare rates, compute the effective rate of your home-equity loan, with the rate on a credit card or auto loan.

Effective rate = rate * (1 - tax-bracket)
Example: If the rate of the home-equity loan is 12% and your tax bracket is 30%, your effective rate is: 12% * (1-0.3) = 12%*0.7 = 8.4%

If your credit card is higher than 8.4%, then the equity loan is cheaper, otherwise it is not.

Besides the interest rate, you may also want to compare monthly payments and other terms of the loan.

9. Getting a home-equity line of credit if you plan to refinance your first mortgage in the near future.

Many mortgage companies look at the combined loan amounts (i.e., the first loan plus the second) even when they are refinancing the first mortgage. If you plan on refinancing your first, check with your mortgage company to find out if getting a second will cause your refinance to get turned down.

10. Getting a home-equity line to pay off your credit cards if your spending is out of control!

When you pay off your credit cards with your equity line, don't go out and charge up those credit cards again and put your house on the line! If you can't manage the plastic, tear it up!