7 Mistakes Associated with Home Equity Loans

A home equity loan can be of two types:

A closed-end loan for a set amount, called a home equity loan (HEL). The money is given to the borrower as a lump sum and no more can be borrowed unless a new loan is established.
An open-ended loan, called a home equity line of credit (HELOC). An initial amount is borrowed, with an end limit established. The borrower can continue to borrow in varied amounts up to the end limit.

More on this topic

Avoid the following mistakes when deciding whether a home equity loan is right for you.

  1.   Fuzzy Understanding of the Difference between a Home Equity Loan (HEL) and a Home Equity Line of Credit (HELOC)

A home equity loan involves a lump sum payout and preset payments, like a mortgage. A home equity line of credit is an open ended loan with a predetermined limit and payouts as determined by the borrower. The monthly pay back is based on the variable interest rate and the outstanding balance.Before choosing either, first determine the need and time frame for the money to be spent. A home equity loan can be beneficial in planning for home repairs or debt consolidation. Taking out smaller sums periodically through a home equity line of credit might make more sense if there’s a need for money over a span of time, such as for college tuition. For the line of credit, the repayment will be based on the amount borrowed at the time it was needed.

  2.   Borrowing against Your Home to Pay Credit Card Bills

Borrowing against a home to pay off credit card debt is a sign that spending is out of control. By taking out a home equity loan, unsecured debt from the credit card is being exchanged for debt secured against the home. Unless spending habits can be curbed, credit card debt is likely to rise again. With credit card debt, only the credit rating is at risk; if the credit card debt is transferred to the home through a loan, the home is now at risk.

3.   Not Shopping Around for the Best Interest Rate Home equity loans are like mortgages in that a customer can shop for better rates. Don’t assume that your current mortgage holder or local bank has the best rate. Make sure to check out other sources, such as credit unions.

4.  Getting Too Large of a Home Equity Loan

Don’t take out more than you need. The amount still has to be repaid. If you have a large home equity line of credit, whether you use it or not, the potential loan amount is considered by other credit institutions as part of your credit liability. Should you need to refinance or get a second mortgage, a large line of credit will be considered at the maximum potential payment in figuring your credit liability.

5.   Assuming Your Home Equity Loan Interest Is Tax Deductible

Don’t assume that all of the interest from your home equity loan or line of credit can be written off like your mortgage interest. You should discuss the tax implications with a finance professional.

6.  Not Finding out the Maximum Interest Rate Possible During the Life of the Loan

A home equity line of credit may have a low introductory rate that can rise considerably after the initial welcome period. Most lines of credit are tied to the prime interest rate, such as prime plus 3%, with prime being the interest rate set annually by a large financial institution and the additional percentage established by the lender. As the prime interest rate rises or falls, this will affect the interest rate paid on the loan. Find out what is the maximum interest rate, or “lifecap,” for the home equity line of credit to avoid future surprises.

7.  Borrowing Money to Invest in the Stock Market

Borrowing money against the home to invest in the stock market is full of risk. The stock market is volatile and, as many people found out in the late 1990s, unpredictable. The home is usually (though not always) the best investment. Make sure the return on investment opportunities outweigh the risks of any investment that uses the home as collateral.

  Additional Information on Home Equity Loans