The kids are begging for a swimming pool while you're daydreaming about tall drinks and lazy summer afternoons in the welcoming shade of a beautiful new veranda. Could a home equity loan be on the horizon?

Home equity loans can be a godsend to homeowners. But before you leverage your home's equity, remember that these are business transactions. Banks don't offer them out of the goodness of their hearts. Here are some common pitfalls to avoid in your pursuit of home equity happiness.

    1. Choosing the wrong type of loan. Home equity loans are essentially second mortgages in which borrowers receive a lump sum of cash. In return, they make payments of principal and interest at a fixed rate for a set period of time. Home equity lines of credit (HELOCs), on the other hand, operate much like the cash advance feature on a credit card. You can tap into a fixed amount of credit by writing a check, or swiping a debit card. HELOC interest rates are variable-as are loan terms-so it's difficult to know exactly how much you'll pay and for how long.

    2. No extra credit. Even if you never make any withdrawals, HELOC funds are still considered part of your available credit. Borrow too much, and you may have trouble getting a loan in the future.

    3. Forgetting about prepayment penalties. You've heard it before-making even one extra mortgage payment can shave a great deal of money off your loan. Request a loan with no prepayment penalty and read the fine print before you pay down your mortgage early.

    4. Ignoring the Good Faith Estimate. Your lender will provide you with a "good faith estimate" to indicate closing costs; but you need to read and understand it. Ask questions if the costs are higher than what you've discussed.

    5. Assuming interest is fully deductible. Planning to deduct the interest on your home equity loan? You can't unless you itemize your deductions and borrow less than $100,000. Brokers and lenders aren't in the tax business-consult a CPA for specifics.

    6. Taking the first great offer. So what if your brother-in-law's a banker and he needs the business. Get quotes from other lenders and then ask your banker to match their offers. You'll be surprised how flexible lenders can be.

    7. Misunderstanding the life cap. HELOCs have a "life cap," or maximum potential increase in the interest rate that you'll pay during the life of the loan. Variable interest rates can rise steeply in a short amount of time, and 18 percent life caps are not uncommon. Don't agree to a HELOC unless you can make the maximum potential payment.

Home equity loans are not risk-free. Do your homework-shop around, ask questions, and read everything before you sign anything. Never forget that you're pledging your home as collateral against the loan. If you're not careful, someone else could be splashing around in your new swimming pool and enjoying a refreshing drink on that gorgeous new veranda.

Published on September 26, 2013