A home remodel, college tuition and emergency need can all require access to a large amount of cash. An obvious choice in many of these situations is tapping into your home equity for a loan. Given that home equity loans can offer lenders big profit margins, however, you should know the repayment terms before signing on the dotted line. Even if the loan is needed only on a short-term basis, borrowers might end up paying more in interest than what they bargained for if prepayment penalties are high.
Very often, home equity loans include a prepayment penalty as part of the lending agreement. According to Bankrate, lenders expect borrowers to carry an outstanding loan balance for at least two or three years. The penalty is a fee the lender charges for early repayment. Penalties usually consist of a percentage of the outstanding balance or several months worth of interest.
By the Numbers
Much of the paperwork for a home equity loan from a bank is essentially like taking out a primary mortgage. Just as with a mortgage loan, a home equity loan comes with its own set of fees and closing costs. According to houselogic.com, expect to pay in the neighborhood of $2,000 in interest for each $100,000 borrowed. Although the loan comes with a fixed interest rate with uniform payments over the life of the loan, closing costs and fees play into the economics as well.
Sense or Nonsense
Borrowing money wisely is one of the tenets of building wealth. Taking out a home equity loan is prudent in situations where the fixed-rate loan money can be tracked on the asset side of the balance sheet. This includes home improvements, which essentially act as an investment in the home's resale value. Other possible scenarios include payment of education expenses or to pay off high-interest loans such as credit cards. Vacations, furniture and fancy cars -- things that hold no return on investment -- are all poor choices for home equity loan financing.
Early Payment Strategies
Although an expedited payment schedule can set up borrowers to take a penalty hit from the lender, a slow and steady approach can pay big dividends in the long run. The most straightforward approach to an early payoff is to add "principle only" money to monthly payments. For example, a borrower with a monthly payment of $500 might choose to send the lender $550 each month with a memo reading "$50 principle only." Once the penalty period has passed, the whole loan can be paid off if the borrower chooses.