Even if you've never hacked your way through a jungle, you can imagine there are plenty of pitfalls. Poisonous snakes, annoying insects, and dangerous species-these are all perils you face when you veer off the beaten path.
Tapping your home equity is no different. With a home equity loan or line of credit, there are as many pitfalls as there are animals in the jungle. However, armed with a few essential facts, you can find a home equity loan that will do more help than harm.
Home equity loans and HELOCs: Two different animals
Even though home equity loans and home equity lines of credit (HELOCs) are both a type of second mortgage on your home, there are significant differences between them. A home equity loan has a fixed rate, fixed loan amount, and fixed repayment schedule.
In contrast, a HELOC works like a credit card. It offers a variable interest rate, and you only tap equity when you need it, up to a predetermined limit. You have a period when you can borrow against it when you wish, called the draw, which is usually 5-10 years. After that, it converts to a fixed-rate loan for repayment of the principle.
Lenders who are too easy can make your life too hard
Some lenders may be willing to lend you more than you actually need. For example, suppose you need $10,000 for a new roof, but the smallest home equity loan or HELOC your lender will do is $20,000. You can take the loan and use just what you need, but having the extra money available makes it all too easy to fritter it away and end up with more debt than you anticipated going in.
Not paying it back on time
If you fail to repay a loan from a friend or family member, you risk losing a valuable relationship. If you fail to make your credit card payments, you risk damaging your credit rating or may even need to declare bankruptcy. If you default on your home equity loan, you risk losing your home.
Living it up in the present, not planning for the future
Some lenders will urge you to "unlock" the value tied up in your home and put it to work for you through a home equity loan. But all loans must someday be repaid. Tapping into your home equity is a convenient way to raise money, but it also puts off the day your home is fully paid for.
Avoid first lender quicksand
Don't go with the first lender you find. There are hundreds of lenders out there – choose a few and compare their home equity loan rates and closing costs. Negotiate your deal and take your time. Remember, you're the buyer. If lenders know you're shopping around, they may sweeten the deal.
Don't get lulled in by low payments
With a HELOC, there's a "live in the moment" risk that comes from the fact the it's usually an interest-only loan during the draw period. This can mislead you into thinking your debt is more manageable than it is, so you use more of your credit limit than you intended. As a result, you face much larger payments when it comes time to begin repaying the loan principle.
HELOC rates may increase
HELOCs start out as adjustable-rate loans during the draw, then typically convert to a fixed-rate loan during the phase when you repay the loan principle. Since draw periods are usually 5-10 years, market mortgage rates may rise substantially between the time you first take out your HELOC and the time your fixed rate is set for repayment, meaning you could end up paying a considerably higher rate than you anticipated.
Don't let costs sneak up on you
A common tactic among unscrupulous lenders is to sneak hidden costs onto a loan, and surprise the borrower with increased expenses at the closing. Avoid this high-pressure tactic by scrutinizing costs before the closing. They'll be detailed in a Good Faith Estimate, which your lender is required to provide. While it's true that the initial statement is just an estimate, final costs should be within a reasonable neighborhood from the original estimate.
Prepayment penalties spoil the party
Paying off your home equity loan early might seem like a smart thing to do. But if your loan includes prepayment penalties, you might be punished for your fiscal responsibility. Not all home equity loans have such penalties, but you may encounter them from time to time. Be sure to ask if your loan will include such penalties before signing on the dotted line.
A home equity loan can be an affordable and financially savvy way to raise needed funds. Be mindful of the above tips, and you can successfully navigate the financial jungle and avoid the most common home equity loan pitfalls.