If you have equity in your home and need cash, a home equity loan can seem like a slam-dunk solution. But like most things, it’s never that easy, and using your home as collateral is no small decision.
If you’re considering a home equity loan, here are eight pitfalls you should be aware of — and how to get around them.
1. Not enough income documentation
Lenders love predictable borrowers who have set amounts of income coming in on a regular basis.
If your income is sporadic and variable because you’re self-employed, work on commission or as a freelancer, or you get income from rental property, a home equity loan is tougher to underwrite.
Avoid the pitfall: Unless you have a steady job and paycheck, expect to be asked for a lot more income documentation. A borrower with atypical income sources should expect to show two years of tax returns. Gather all the income verification you can, and have it ready to give to your lender.
Do you know how much house you can afford? Use our calculator to find out.
2. Unexpected payment hikes
During the housing bubble, a lot of homeowners who got home equity loans or refinanced ended up in foreclosure. Loans that had balloon payments or low “teaser” interest rates — features that many borrowers didn’t completely understand — were part of the problem.
Avoid the pitfall: To escape the unwelcome surprise of a monster payment increase down the road, understand all the terms. Get answers to these questions:
- Under what circumstances could interest rates or payments increase?
- Is there a limit on how high they could rise — and how would you cover that?
- Will each payment be the same for the life of the loan?
- Are there any prepayment penalties if you sell the home or decide to pay off the loan early?
- What will it cost you — upfront and over the life of the loan — to borrow this money?
3. Converting unsecured debt to secured debt
During the go-go years leading up to the 2008 housing bubble, consumers were tapping home equity to pay off credit cards. That’s great for the card issuers, but it’s a bad move for consumers.
Here’s why: Credit card balances are “unsecured debt.” That means there’s no collateral. If you don’t pay back the card balances, your creditors will put a stain on your credit. If the amount is large enough, they might sue and try to garnish your salary. But they can’t just come in and take enough of your assets to satisfy the loan.
Not so with a home equity loan. Your collateral is your house. And if you don’t repay the loan, the bank can take it.
Avoid the pitfall: Never spend the cash equity in your home to pay off credit cards or other unsecured debt. That sounds like a no-brainer, but many homeowners make this mistake. Using the equity to add value to your house? Now, that’s smart.
4. Not looking into all of your options
Some reasons to take out a home equity loan make better sense than others. How about using equity money to buy a depreciating asset, like a car? No, no. The car is used as collateral for an auto loan, so why add your house to the deal?
Plus, you might be able to get a good rate on an auto loan through a bank or the car dealer.
What about using home equity to pay for your kid’s college education? Whether or not you realize it, you and your child are likely to have other avenues for this expense, too, like student loans.
Avoid the pitfall: It pays to look into all the alternatives before you start using your house as collateral for purchases and expenses. “I would explore all options before I turned to a loan against my house,” says Ira Rheingold, executive director of the National Association of Consumer Advocates.
5. Letting someone who stands to profit talk you into it
Be very wary of a contractor or other professional who is pushing you to take out a loan or steering you toward a specific lender or loan broker, says Sarah Wolff, former senior researcher for the Center for Responsible Lending.
Or how about getting home repairs or renovations done by someone who also offers financing?
“It could be a bad sign,” Wolff says.
Avoid the pitfall: No matter what you’re doing with the home equity money, you need to shop lenders. Get estimates from a few different types of lenders (banks, credit unions, brokers) when you’re searching for the best deal. And don’t just accept a loan offer from a contractor who’s adding on a room to your house, for example. “You have to view them separately,” Rheingold says.
6. Not having a payoff strategy (and contingency plan)
If you’re relying on a future windfall (a raise, bonus, commissions) to pay back a home equity loan, what happens if the money doesn’t materialize? Are you planning to pay it off when you sell the home? You could find yourself in serious financial trouble if you don’t think ahead.
Avoid the pitfall: Anytime you borrow money, you need a repayment plan. If you expect to repay the loan when you sell the house, know how long you need to stay in the place to cover your closing costs. And what’s your strategy if you can’t recoup the loan balance when you sell? You’d better have a strategy before you take out the loan.
7. Not understanding your risks
Even if the home equity loan is much smaller than your home’s value, if you fall behind on payments, the lender can take the home.
“That is, hands down, the biggest thing,” Rheingold says. “Take a look at what you saw in the rah-rah 2000s. A lot of foreclosures were second mortgages or cash-out refis.”
Avoid the pitfall: Do your homework and understand that you could lose the roof over your head if you mess this up. A home equity loan is a great way to borrow, but only if you don’t go into it blindly or take unnecessary risks.
8. Shopping passively (or not at all)
Don’t expect to get the best rate through a secret handshake, by “knowing a guy,” or going with the first offer.
Your credit score, debt load and the amount of equity you have in your home all play a huge part in the deal, but that doesn’t mean all lenders will view you the same way or even make similar offers. While lenders often consider the same factors, they’re not necessarily looking for the same results.
Avoid the pitfall: It’s simple, really: You get the best terms by shopping around and letting lenders compete. You can do better if lenders know they’re one of several vying for your business.