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Top 10 Mistakes when Getting a home-equity loan

Article 647 - October 05, 2006

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Not knowing if your loan has a pre-payment penalty clause. If you are getting a "NO FEE" home-equity loan, chances are there's a hefty pre-payment penalty included. You'll want to avoid such a loan if you are planning to sell or refinance in the next three to five years.
Getting too large a credit line. When you get too large a credit line, you can be turned down for other loans because some lenders calculate your payments based upon the available credit--not the used credit. Even when your equity line has a zero balance, having a large equity line indicates a large potential payment, which can make it difficult to qualify for other loans.
Not understanding the difference between an equity loan and an equity line. An equity loans is closed--i.e., you get all your money up front and make fixed payments until it is paid if full. An equity line is open--i.e., you can get numerous advances for various amounts as you desire. Most equity lines are accessed through a checkbook or a credit card. For both equity loans and lines, you can only be charged interest on the outstanding principal balance.

Use an equity loan when you need all the money up front--e.g., for home improvements, debt consolidation, etc. Use an equity line of credit when you have a periodic need for money, or need the money for a future event--e.g., childrens' college tuition in the future.
Not checking the lifecap on your equity line of credit. Many credit lines have lifecaps of 18 percent. Be prepared to make payments at the highest potential rate.
Getting a home-equity loan from your local bank without shopping around. Many consumers get their equity line of credit from the bank with which they have their checking account. By all means, consider your bank, but shop around before making a commitment.
Not getting a good-faith estimate of closing costs. See item number four above.
Assuming that your home-equity loan is fully tax-deductible. In some instances, your home-equity loan is NOT tax deductible. Do not depend on your mortgage company for information regarding this matter--check with an accountant or CPA.
Assuming that a home-equity loan is always cheaper than a car loan or a credit card. Even after deducting interest for income tax purposes, a credit card can be cheaper than a credit line. To find out, compare the effective rate of yourhome-equity line with the rate on your credit card or auto loan.

Effective rate = rate * (1 - tax bracket)
Example: The rate of the home equity line of credit is 12 percent,your tax bracket is 30 percent, your effectiverateis: .12 * (1 - .3) = .12 * .7 = .084 = 8.4 percent.
If your credit card is higher than 8.4 percent, the equity loan is cheaper.
Getting a home equity line of credit when 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) when 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 be turned down.
Getting a home equity line of credit to pay off your credit cards when your spending is out of control! When you pay off your credit cards with an equity line, don't continue to abuse your credit cards. If you can't manage the plastic, tear it up!

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