Home equity loan - cost of the loan

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Interest is the most expensive cost in a loan. Rates on home equity loans are either fixed or variable. Fixed rates stay the same over the life of the loan while variable rates move up and down.

Competition among lenders has many of them offering low introductory "teaser" rates, one or two points below prime, that are good for about six months. After that, the rate is adjusted according to a public index that reflects interest trends. The lender uses that index to decide how much the annual percentage rate will change during the life of the loan. Banks must use a public index rather than an internal one that could be arbitrary.

Most banks use The Wall Street Journal prime rate or the prevailing rates on Treasury notes as the basis for their home equity loan interest rate calculations. The all-important Journal number is derived from the base rate on corporate loans posted by at least 75 percent of the 30 largest U.S. banks.

The lender adds a margin, or fixed number of percentage points, to the index to determine the new rate each time it is adjusted. This can happen once a year or more. Each point is equal to 1 percent of the loan, so if you're borrowing $10,000 one point would be $100.

By law, variable-rate loans must 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.

Tips

• Ask the lender:
  • How much can a variable interest rate go up at one time?
  • What is the cap on a variable rate?
  • What is the maximum monthly payment? The minimum?
  • How often can you change the rate?
  • What index do you use and how high has it risen in the past?
  • Is the loan amortized, or is there a balloon payment? If not fully amortized, how much is the balloon and when is it due? (If there is a balloon, you don't want to be surprised when the end of the loan rolls around and there is a lump sum payment due you hadn't been aware of.)
• Understand that you cannot compare the annual percentage rate -- the cost of the loan each year, expressed as a percentage -- of a term second mortgage with a line of credit. They are calculated differently. The APR for a 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. You usually need to have your loan from the same financial institution you have a checking or savings account to do this.
• Before you sign, consult a tax adviser about deductions on your loan because there are exceptions to deductibility.

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