home equity

True costs of a $20,000 home equity loan

Don TaylorDear Dr. Don,
I am interested in borrowing about $20,000 against our current home, which is valued at about $300,000. We do not owe anything on the house.

For the loan, I only really need about half of the $20,000 required for the project, but it looks like the costs associated with interest rates and closing costs are high enough to give me doubts about taking a home equity loan at this time. I need to make a decision pretty quickly. What would you advise?

Thanks,
-- Susan Scamper

Dear Susan,
You are smart to focus on closing costs in deciding the best way to finance your project. Taking out more than you need to lower your average cost of financing doesn't make sense. You would be paying interest expenses on money you don't really need.

You should also consider how long you expect it will take to pay off the loan. Prepayment penalties on a home equity line of credit can also add to your expenses.

Home equity lines of credit don't include the closing costs in the annual percentage rate calculation. By contrast, the APR on a home equity loan will include points and closing costs in the calculation.

A home equity line of credit is really an adjustable-rate loan, with interest-only payments in the early years. There can be annual participation fees and a transaction cost every time you draw on the credit line. The advantage is that after the initial draw at closing, you may borrow only what you need.

A home equity loan has a fixed interest rate and is amortized. That means the monthly payments cover both the interest expense and repayment of principal over the loan's term.

If you have an employer providing a 401(k) plan, you may be able to get a plan loan to finance the project. That would help you avoid the closing costs associated with a home equity line or loan.

If you have savings account, you could consider a so-called CD loan. Here, the bank uses your certificate of deposit as collateral, loaning you the money you need for the project. Good luck!

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