Traversing the world of home equity loans can feel like trying to solve a puzzle. You’ve probably heard they’re a great way to fund a major home renovation, pay for college tuition, or consolidate debt. While that’s true, it’s also essential to remember that taking out a loan is a significant financial decision. Before you sign on the dotted line, it’s crucial to look beyond just the interest rate and examine all the potential costs associated with a home equity loan.
At Choice One, being a smart borrower starts with being an informed one. Let’s pull back the curtain and take a detailed look at the actual costs, fees, and key considerations associated with a home equity loan.
Understanding the Basics: What is a Home Equity Loan?
As you pay down your mortgage, the amount of your home that you actually own, or its equity, as it’s called, grows. A home equity loan allows you to borrow a lump sum of cash against that built-up equity. It’s a second mortgage on your home. You will repay it over a set period with fixed monthly payments.
Unlike a HELOC (Home Equity Line of Credit), which is more like a credit card with a revolving line of credit, a home equity loan gives you all the money upfront. This makes it an excellent option for projects with a specific, known cost, like a kitchen remodel or a new roof. Let’s get into the nitty-gritty of what you need to consider before you take out a loan. To help, we put together a list of nine things to consider when shopping for a home equity loan.
Nine Important Considerations When Shopping for a Home Equity Loan
1 The Real Cost: Interest Rates and APR
While it might seem obvious, the interest rate is the first thing most people look at, and for good reason. It’s the primary cost of borrowing the money. A home equity loan typically has a fixed interest rate, which means your monthly payment will remain the same for the entire life of the loan.
However, don’t stop there. You should consider the Annual Percentage Rate (APR), not just the interest rate. The APR includes the interest rate plus any additional fees, providing a more accurate representation of the total cost of borrowing. A savvy shopper compares the APRs from different home equity lenders to find the best deal.
For example, imagine two lenders offer what appears to be the same interest rate. But one lender has a lot of extra fees tacked on, which drives up the APR. By comparing the APR, you can see which loan is genuinely more affordable in the long run.
2 What Fees are Involved with a Home Equity Loan?
Just like with your original mortgage, a home equity loan comes with closing costs. These are separate home equity fees that cover the administrative and legal costs associated with the loan. These fees can vary significantly from one lender to another and may include:
- Appraisal Fees: A professional appraiser will need to determine the current value of your home to calculate how much equity you have.
- Application Fees: Some lenders charge a small fee to process your application.
- Loan Origination Fees: This is a fee charged by the lender for the work of processing and underwriting the loan.
- Title Search and Insurance Fees: A title search ensures that your property is free and clear of any liens or ownership disputes.
- Attorney Fees: In some states, a real estate attorney is required to be involved in the closing process.
Fees associated with a home equity loan may seem endless. Those mentioned above, along with other fees, can often cost thousands of dollars. Some fees are set in stone, while others are negotiable. It’s always best to shop around to see which lender not only offers the best rate, but also the lowest fees. A low rate is great, but if the closing costs are triple, you’ll just be swapping one debt for another.
Request a good-faith estimate from each lender for comparative purposes. This estimate will display your total expected fees. You may see fees including points, title search, title insurance, origination fee, documentation preparation, administrative fee, underwriting fee, and even a prepayment penalty. Many of these excess fees are appropriately referred to as “junk fees,” or excess charges that lenders impose at closing. These “junk fees” often take borrowers by surprise, which is why it’s essential to be prepared and conduct thorough research on multiple lenders.
Some lenders may roll these costs into the loan, but this means you’ll pay interest on them over the life of the loan. Other lenders may require you to pay them up front. As mentioned, make sure you ask your potential home equity lenders for a clear breakdown of all associated fees. A good lender will be transparent about these costs from the start.
Did we mention that Choice One offers members a NO FEE* Home Equity Loan? Click here to find out more!
3 Credit Score Really Does Matter
Your credit score is like your financial report card, and it plays a huge role in the interest rate you’re offered. Lenders use your score to gauge how risky it is to lend you money. The best home equity loan rates advertised by lenders are typically offered to borrowers with the highest credit scores. Before you sign, ensure you are getting the low rate you saw advertised. If your credit score is not good, your local credit union representative can offer you tips to improve it before you apply for a loan. Just another way credit unions live their motto of “people helping people.”
A great credit score could save you thousands of dollars over the life of the loan. Before you even start shopping for a loan, it’s a good idea to check your credit score and review your credit report for any errors. If your score isn’t where you want it to be, taking a few months to improve it can be a wise financial move. This could involve paying down some credit card debt, ensuring all your payments are made on time, and avoiding the opening of new lines of credit. To learn more about how you can improve your credit score, read our blog, “4 Main Factors Impacting Your Credit Score.”
4 Do I Need to Insure the Loan?
This is a question that many people often overlook. While it’s not always required, some lenders may require you to purchase specific insurance coverage as a condition of the loan. This is to protect their investment in your property.
Additionally, you may want to consider purchasing optional insurance, such as life or disability insurance, that would cover your loan payments if you were unable to work. This isn’t a cost of the loan itself, but it’s a financial safety net to consider.
5 What’s the Repayment Policy, and is there an Early Payoff Penalty?
When you opt for a fixed-rate home equity loan, you will have a fixed monthly payment for the term of that loan. Simple. You’ll always know what your payment will be, and it will never change, which is a plus when it comes to budgeting. On the other hand, if you decide to take a HELOC, your interest rate may fluctuate, and your payments will follow suit based on the current interest rate and also the amount you borrow over time. Like everything, there are pros and cons to both. When speaking with lenders, be sure to obtain the repayment policy in writing for comparison to determine which one works best for you.
Many home equity lenders will charge a penalty if you pay off your loan early. This is called a prepayment penalty. It’s designed to protect the lender from losing out on the interest they would have earned over the full term of the loan.
Before committing to a loan, always ask about the repayment terms. Is there a prepayment penalty? If so, what is it and how long does it last? This is especially important if you think you might sell your home or pay off the loan early, such as with a bonus or inheritance.
6 Are There Any Tax Benefits?
The good news is that under certain circumstances, the interest you pay on a home equity loan may be tax-deductible. However, this is a significant “may.” The tax benefits of home equity loans are not a guarantee.
According to the IRS, you can only deduct the interest on a home equity loan if the money is used to “buy, build, or substantially improve” the home that secures the loan. Using the loan for a kitchen remodel or a new addition might make the interest tax-deductible, but using it to pay off credit card debt or fund a vacation would not.
Tax laws can be complex and are subject to change over time. It’s always best to consult with a qualified tax advisor to understand how a home equity loan could affect your personal tax situation. This is a crucial step to avoid any surprises come tax season. To learn more, read our blog, “When are Home Equity Loans Tax Deductible?”
7 What Happens to My Home if I Default?
This is a serious consideration. Remember, a home equity loan is a second mortgage. If you default on the loan, meaning you stop making your payments, your lender has the legal right to foreclose on your home. This is a risk that you must be prepared for, which is why it’s so important to be confident in your ability to make the monthly payments.
Before taking out a loan, carefully consider your current financial situation and future plans. Do you have a stable job? Do you have an emergency fund? A home equity loan is a significant commitment, and you should only take it on if you’re sure you can handle the responsibility.
8 What’s the Time Commitment?
The length of your loan, also known as the loan term, directly impacts your monthly payment and the total interest you’ll pay. A shorter loan term means higher monthly payments, but less interest paid over the life of the loan. A longer term means lower monthly payments, but more interest paid overall.
For example, imagine a $50,000 loan. A 10-year loan will have a higher monthly payment than a 20-year loan, but you’ll pay it off much sooner and pay less total interest. It’s a trade-off between affordability now and the total costs of a home equity loan over time.
9 Should I Consider Other Types of Loans?
A home equity loan is not a one-size-fits-all solution. Depending on your needs, other types of loans might be a better fit. As mentioned before, a HELOC might be a better choice if you need a flexible way to fund ongoing projects or unexpected expenses. A personal loan might be an option for a smaller amount, especially if you don’t want to use your home as collateral.
It’s wise to consider your specific needs and compare different loan products. A friendly and knowledgeable lender, like Choice One, can help you explore all your options and find the one that’s right for you. They’ll take the time to listen to your goals and help you understand the pros and cons of each loan type.
Making an Informed Decision
Taking out a home equity loan can be an excellent way to use your home’s value to improve your financial situation. But it’s not just about the interest rate. By looking at all the potential costs of a home equity loan, from closing costs and fees to the impact on your credit score and your use of the loan, you’ll be able to make a confident, well-informed decision.
Finally, if you do decide to move forward with applying for a home equity loan, request copies of any forms or contracts you’ll be signing at the closing in advance so you can read them thoroughly beforehand. Ask the lender specifically if there were any changes to the good-faith estimate provided. If you find any discrepancies or are unsure about something, please ask questions.
At Choice One, we’re here to be your trusted financial partner. We provide clear, straightforward information so you can choose the best path forward.
A home equity loan from Choice One is the smarter way to borrow. Tap to learn more, view rates, and apply for a home equity loan.
*No Closing Cost Promotion applies to the first lien only. Third party fees will be reimbursed for the cost of originating your loan excluding any property tax or transfer fees. Fee Reimbursement–The lender may have paid some third party fees associated with this loan. Please refer to the Closing Disclosure provided prior to loan closing for an itemization of third party fees paid by the Borrower (if applicable), and those paid by the Lender on the Borrower’s behalf. The Borrower agrees to reimburse the Lender the actual amount of bona fide third party fees paid on the Borrower’s behalf, as permitted by applicable law, if the loan is paid off within twenty four (24) months after consummation.