Fees and closing costs

A home equity loan almost always carries fees and closing costs. Many lenders don’t charge fees or closing costs on credit lines. If your lender does charge fees to open a credit line, don’t rule out that offer immediately; maybe there are other features that make it a good deal. But shop around.

The fees that you pay for opening an equity account are similar to the ones you pay when you buy a home. The fees can total 2 percent to 5 percent of the loan and are for such things as:

• Property appraisal
• Application
• Title search
• Attorney or title agent
• Document preparation

The most common fee levied on a credit line is for an appraisal or other estimate of the property’s value. Sometimes, instead of paying an appraiser to visit the house and compare it to other nearby homes of similar value, the lender accepts a computerized estimate called an automated valuation model, or AVM. Or a real estate agent might estimate the value in what is called a broker’s price opinion, or BPO. AVMs and BPOs cost less than full appraisals.

Other fees and interest

The biggest cost you will pay on an equity loan or a credit line is the interest. Home equity loans usually have fixed rates, and credit lines usually have variable rates. If you get an equity loan on the same day that your neighbor gets a home equity line of credit (HELOC), your rate will be higher than your neighbor’s. Over time, your neighbor’s HELOC rate can rise higher than what you pay on the equity loan, but your rate never changes.

Some lenders offer teaser rates that are artificially low for a few months, then adjust to normal levels. The variable rate of a HELOC moves up and down with another rate, called an index. Most banks index HELOC rates to the prime rate or the prevailing yields on Treasury notes.

The lender adds a margin, or fixed number of percentage points, to the index to determine the new rate each time it is adjusted. For example, a HELOC might use the prime rate as an index, with a margin of 1 percentage point. If the prime rate is 3 percent, the HELOC’s rate is 4 percent (the 3 percent prime plus 1 percent margin). If prime rises to 3.5 percent, the HELOC’s rate will rise to 4.5 percent. Adjustments can be made monthly, quarterly or annually.

Variable-rate loans have a cap on how high the interest can climb over the life of the loan. Most variable-rate lines of credit also have a cap that limits how much, and how often, the interest rate can change during the course of a year. This cap typically prevents the rate from jumping more than two percentage points in a year. Some plans require a minimum monthly payment. Chart out how high your payments would be at different rates by going to Bankrate.com’s mortgage calculator or ask your banker to do it for you.

Credit lines sometimes have other fees attached to them, such as annual maintenance charges, transaction fees each time you use the account, or inactivity fees if you don’t use the account. Both types of equity debt may be subject to prepayment penalties, which are charged if you pay off or close the account within two or three years.

If you expect to sell the house within a couple of years, don’t get an equity account with a prepayment penalty.

Tips

• Check out rates in Bankrate.com’s survey of home equity rates and compare.
• Ask the lender what the lifetime and periodic caps are.
• Find out if there is a minimum payment.
• Understand what index is used, what the margin is, and how often the lender adjusts rates.
• Ask whether there is a balloon payment — a requirement that the entire balance is due in a lump-sum payment after a few years.

Understand that you cannot compare the annual percentage rate — the cost of the loan each year, expressed as a percentage — of a home equity loan against a home equity line of credit. They are calculated differently. The APR for a fixed-term equity loan takes into account the interest rate plus points and other finance charges. For a line of credit, the APR is based on the periodic interest rate and does not include points and other costs.

Electronic payments sometimes get you a fractional break on interest rates. Before you sign, consult a tax adviser about deductions on your loan because there are exceptions to deductibility.