Top 10 Home Equity Loan Mistakes
Here are the top 10 mistakes people make when considering a home equity credit line.
1. Being Unaware of the Difference between a Credit Line and a Home Equity Line of Credit
An equity loan (also called a closed end second mortgage, CES) is a one-time transaction that allows you to draw out all the funds available.
A home equity line of credit (HELOC) is open; you can choose a small initial advance against the full amount of the line; then reuse the line of credit as often as you want during the period that the line is open. Your monthly HELOC payment is based upon the outstanding balance.
Determine before you make this decision which type is best for you. A credit line allows you to initially withdraw funds, and you can then withdraw funds at a later time as needed. Payments of this loan are based on the balance due.
A general rule of thumb is: use an equity loan when you need all the money up front; such as money for home improvements, debt consolidation, or large one-time purchases. Choose a credit line if you have an ongoing need for money or need the money for a future event. Paying for your child's college tuition each semester for three years is an example of where a HELOC may be the preferred financing option. You limit the amount of interest you owe at any one time as interest charges are based solely on the money currently owed.
2. Getting a HELOC if You Plan on Refinancing Your First Mortgage
Many mortgage companies look at the combined loan amounts (i.e., the sum of the first and second loans) even when you are refinancing only your first loan. If you plan on refinancing your first loan the lender may require you to pay off both your first and second mortgages; or close your home equity line completely. Check with your mortgage company to see if having a second loan will cause your refinance to be turned down.
In some instances lenders may allow you to keep your existing second mortgage while refinancing your first mortgage. This is done by obtaining a "subordination agreement" from the lender who provided you with your second mortgage. Talk to your mortgage company if you are interested in keeping your second mortgage or HELOC while refinancing your first. Examine the interest rate of a credit line versus a refinance, and determine which is best for you.
3. Getting a HELOC to Pay off Credit Card Debt
If you feel you must take out a home equity loan or open a line of credit to pay off credit card debt, then your credit card spending is out of control. When you pay off your credit cards with your credit line don't put jeopardize your ability to make your mortgage payments by charging large amounts on your credit cards again! If you are having a hard time managing credit and controlling your spending habits seek advice or counsel from a trusted source.
Remember, a home equity loan or credit line uses you home as collateral. You may jeopardize your home if you are spending too much on credit cards, and need a line of credit to manage them.
4. Assuming an Equity Loan is cheaper Than a Credit Card
The typical rate of most credit cards is 6.9%. A credit line is generally in the neighborhood of 12%. Allowing for tax deductions, determine which rate is the best for you over the long haul. Remember that you are not guaranteed tax deductions on every credit line. Also, keep in mind that in most cases you are using your home as collateral. A credit card may just suit your needs.
Effective rate = rate * (1 - tax bracket)
Example: If the rate of the home equity credit line is 12% and your tax bracket is 30%, your effective rate is12% * (1 - 0.3) = 12% * 0.7 = 8.4%
If your credit card is higher than 8.4%, the credit line is cheaper. Besides the interest rate, you may also want to compare monthly payments and other terms of the loan.
5. Getting a Credit Line from Your Banking Institution
Many consumers get their credit line from the bank with which they have their checking account. This is a costly mistake. As in any other type of loan, be sure to shop around for the best deal. Your current bank may not be able to give you the best interest rate or credit line you desire. There are lenders which specialize in second mortgages and credit lines that can offer you lower fees and better interest rates. Local banks may be limited in the type of product available to you. Shop around before deciding to use your bank; you may find that there is another lender out there that can offer you a substantially more attractive loan program. It always makes good sense to approach 3 different lenders before you make your decision.
6. Getting Too Large of a Credit Line
Getting a credit line that is larger than what meets your needs may cause you to be turned down for other loans. Lenders will consider this credit line when you may have a need to refinance or taker out a second mortgage. Some lenders calculate your credit line payments based upon your total credit liability; even if your credit line currently has a zero balance. The bank uses this calculation because they cannot guarantee that you will keep your credit line at zero in the future. Having a large credit line indicates the potential for large future payments. Large payments on your credit line reduce the available cash you have to pay for other obligations; making it difficult to qualify for other loans.
7. Forgetting to Check Your Credit Line to See if There is a Prepayment Penalty Clause
If you find your credit line has a "NO FEE" advantage, be sure to look for a prepayment penalty clause. This can be very important (and costly to you) if you plan to sell or refinance your home before the pre-payment penalty expires. Paying off a credit line before the end of the term can cost you a lot of money in prepayment penalties. If you plan on selling your home in the next 3 to 5 years, this penalty can become very expensive for you.
When determining whether to include a prepayment penalty on your credit line be sure to do your best to forecast any potential changes in your life that may require you to sell or refinance your property.
8. Not Knowing the Lifecap on Your Credit Line
A "lifecap" is an industry buzzword for the highest interest rate you may see in the life of the loan. While many credit lines offer low introductory "teaser" interest rates that are at, or below the prime interest rate; they often have lifecaps of 18%.
Be sure that you know what the lifecap is before signing. Other lenders may have a better lifecap that will save you a substantial amount of money in the long run. Once the teaser rate period expires, the credit line interest rate may adjust higher; and can continue to adjust based on the current interest rate environment. Be prepared to make high interest payments if rates move upwards.
9. Forgetting to Get a Good Faith Estimate before Closure
As in any type of loan, it is imperative that your mortgage company provides you with a written good faith estimate of closing costs within 3 working days after receipt of your completed loan application. However, don't make the mistake of shopping for your mortgage via a simple comparison of good faith estimates! In fact, a GFE that has a substantial portion of the fees marked zero may be a warning sign that not all program fees are being disclosed up front. Make sure to inquire whether all fees are accurately reflected on the document.
Note: Many fee items on the GFE may be blank if you are considering a "no cost" home equity line of credit. In this instance your GFE may have relatively few fees included.
10. Not Assuring That Your Home Equity/Credit Line is Tax Deductible
Don't assume that your credit line or home equity loan is tax deductible like your mortgage payments. In some cases it is not. It is beyond the scope of this document to provide tax advice or quote from the IRS code. However, do not make the mistake of assuming that simply because the interest paid on your first mortgage is tax deductible that interest paid on a second mortgage or HELOC receives the same favorable tax treatment.
Always check with a tax attorney or CPA to be sure if this applies before you take on the debt load.