Home Equity Loans; The Good, The Bad, The Ugly

Your home is a valuable asset. It can be a “forced savings” even if you haven’t made any other investments. This investment can be a safety net if you come across a need for money. It takes many years to pay down your mortgage and build up equity, but over time it can amount to much more than you would ever be able to put away otherwise.

Home equity is the amount of the value of the home, minus the amount of any loans that use the home as collateral. Many homeowners watch property values appreciate as they pay down their home loan, compounding the financial benefits of owning a home.

Home equity loans allow homeowners to tap into their investment. This can be a fairly quick and easy way to access money needed for what life throws at you. Many lenders are available to you, but you must be sure you get a home equity loan for the right reasons, and with the right lender.

These loans use your home as collateral, so if you don’t pay, you can lose your home in foreclosure. Be sure you are making the best decision before you get a loan that attaches debt to the home that your family depends on.

The Good
Using a home equity loan to make improvements to your home is a great way to improve your lifestyle and the value of your home at the same time. You love your house and don’t want to move, but the kitchen is outdated, you need to add a room, or you’d like to have a bigger garage. Improvements that make your home a better place to live will let you enjoy your home more than you already do, and may make your home worth more in the real estate market if you ever decide to sell it.

Funding your education to eventually increase your income can be a valuable way to use the equity in your home. Home equity loans usually charge less interest than student loans, and the interest is tax deductible. Just be sure that the extra income you receive from furthering your education makes the additional debt worthwhile. Also, check for scholarships and grants, and compare terms of student loans before you jump into deciding a home equity loan is the way to go.

You might have medical bills that you can’t possibly afford any other way. Try to avoid this situation by carrying enough health insurance, but if it’s too late, a home equity loan may allow you to meet your financial obligations. Your home might be a valuable asset, but your health is, by far, your MOST valuable asset.

Consolidating debt can be a good use of your home equity. Home equity loan interest is usually a lot lower than credit card and personal loan interest; so consolidating this into one payment with lower, tax-deductible interest can make your debt payments more manageable. But be careful - this only works if you are committed to paying off your debt and not running up new debt.

The Bad
Using the equity in your home for expensive, unnecessary purchases is probably a bad decision. Autos that depreciate immediately after purchase, appliances that will need replacing in five years, and vacations that are over in two weeks are not worth paying interest on for fifteen to thirty years.

Do you really want to take away what you’ve invested in your home for short-term desires? Be willing to call it a loss if you decide to use the equity in your home for disposable material extras. It’s much better to save the old-fashioned way and pay for these things when you can truly afford them.

While home equity loans are popular for homeowners who want to pay off all their other debts and trade it for one big payment, using a home equity loan to consolidate debt can cause financial ruin if old habits are continued. Many people consolidate debt due to high credit card balances, thinking that they will reduce their interest rates and their monthly payments, and receive tax benefits.

The payments are lower because the amount owed is paid off over a much longer period of time, so even though the rate may be lower they can easily pay a larger amount of total interest. The tax savings might not be worth paying that interest over fifteen to thirty years. The credit cards and personal loans that are to be paid off with this home equity loan may be tempting to use, as irresponsible borrowers will see them as “new money.”

Many consumers have gotten into the debt cycle to begin with by overspending and living beyond their means. If you resolve to start fresh and only spend what you can afford, debt consolidation can help you get back on track, but do not get a loan secured by your house if you don’t have the discipline to control your spending.

The Ugly
The home equity loan industry provides many opportunities for predatory lending. You have something that they want, and some lenders will resort to unethical, or even fraudulent and illegal tactics to take your home away from you.

Predatory lenders loan money to homeowners, securing the debt with their house with the actual intent of eventually foreclosing on the home. Some homeowners are more likely to be targeted, including elderly widows, low-income people, and consumers with poor credit, but any uninformed borrower can fall prey to these unscrupulous lenders.

One of these practices is known as equity stripping. Predatory lenders loan money based on the equity in the home without regard to the borrower’s income. They aren’t concerned if the homeowner truly can’t afford the agreed upon terms. The homeowner will make the payments for a while, incur new debt, eventually fall behind on payments, and then they will swoop in and foreclose on the property.

Be sure that if you get a home equity loan, you can realistically make the payments. Draw up a budget with your truthful spending habits. Make your decision based on what you know you can afford, not on what the lender wants to approve you for.

Some loans require a large balloon payment at the end of the loan term. This might seem inviting to borrowers, because the monthly payments are commonly pretty low. The payments are low because they mostly go to pay interest, so hardly a dent is made in the principal by the time the balloon payment is due.

In the worst scenario, the payments don’t cover all the interest, so you’d have to pay a lump sum more than the amount borrowed to begin with, in addition to your earlier monthly payments. That’s called negative amortization; it means you owe more on your loan as time goes by, since your payments aren’t even enough to cover the accruing interest.

A home equity loan with a balloon payment might make sense if the borrower truly can’t afford the loan any other way, and they will have access to money in a trust fund at a certain age, or they know they will be selling some other property before the balloon payment is due.

Don’t be fooled into hoping you’ll win the lottery or that you’ll “somehow” come across the required payment, or there’s a good chance you could lose your home to foreclosure. If you know you can save up the amount to cover the balloon payment in the time allowed, you’d be better off getting a loan with traditional terms.

Loan flipping is another tactic used by predatory lenders. They sell you a loan, promising better rates than you currently have. They may be able to offer better rates, but with these better rates come new closing costs, new fees, and new points. After you make regular payments for a while, they will entice you with even better rates than they were able to give before because you’ve been such a “good customer”.

This new loan will no doubt cost you more in fees, and they will just add that amount plus the amount of your previous loan’s fees to the principal. Of course they can offer you better interest rates, if they can increase the amount of your principal in doing so. Be sure you plan on staying in your current home long enough to make it financially worthwhile before you even consider refinancing your loan to get better interest rates - usually, about five years is needed to recoup those closing costs.

Credit insurance packing is another common practice to be cautious of. The predatory lender has lots of papers for you to sign at closing, and hopes you don’t read all the details. One of those papers is for credit insurance. They will try to scare you into buying insurance that you really don’t need - “Where will your family live if something happens to you?”

They may pressure you to agree and sign by telling you that all the papers have to be rewritten and that it could delay the loan for days. They may misconstrue that the insurance premium is included in your mortgage payment, so you think there won’t be an additional charge.

Whatever the case may be, don’t let them trick you into buying insurance from them; you don’t want predators to earn a sales commission from your being misinformed. Skip the credit insurance, and get an affordable term life insurance plan to cover all your debts, including your mortgage. Then you can rest assured that your family will not lose their home if the worst should happen.

Your Decision
Whatever you decide to do with the money and whom you get it from is totally up to you. Just be sure that you research all your options very carefully, and get legal and financial advice from a professional when needed. You’ve worked hard for your home; don’t take out a loan on it without being fully aware of all the possibilities and risks. A home equity loan will have either a positive or negative impact on your finances - there's no in-between. Be sure you are making the right choices and for the right reasons.



Sources:
The American Bar Association Guide to Credit & Bankruptcy; Random House; 2006
www.ftc.com