Home Equity Loan Pitfalls

The home equity loan came of age in 1996 when changes in the tax law eliminated deductions for the interest on most consumer purchases. Interest paid on home equity loans, however, remained exempt, up to $100,000 for taxpayers filing jointly.

The two main types of home equity loans are fixed-rate loans and variable-rate lines of credit (called HELOCs). The terms for both range from five to 15 years. With fixed-rate loans, the monthly principal and interest stay the same. Adjustable-rate loans usually start at a lower interest rate—meaning a lower monthly payment—but can climb to a predetermined cap based on market conditions.

Most banks and mortgage companies are happy to make home equity loans because the loan is secured by a tangible asset that can be seized and sold to satisfy the debt if necessary, which minimizes their risk. But the ease with which homeowners can cash out their equity—sometimes up to 125% of the value of the home—brings with it certain pitfalls.

Reloading

Home equity loans are appealing to people who have fallen into a downward spiral of spending and borrowing. The cycle of getting a loan to pay off debt and free up credit that is then use to make additional purchases is called "reloading."

Reloading leads to accelerated borrowing that can result in homeowners getting upside down on their home loans, e.g. owing more than the home is worth. The loan is no longer fully secured by collateral and if the borrower’s income goes down or the home’s market value plummets, the owner could face foreclosure or bankruptcy.

People who consolidate their credit card bills or car loans into a home equity loan are transferring unsecured debt to secured debt and putting their home in jeopardy.

Home Equity Scams

Another pitfall is predatory scammers. The Federal Trade Commission warns about, "Unscrupulous lenders (who) target older or low-income homeowners and those with credit problems. These lenders may offer loans based on the equity in your home, not on your ability to repay."

Avoid lenders who tell you to falsify information on the application, e.g. saying your income is higher than it is to qualify for the loan.

Avoid lenders who don’t provide the required loan disclosures or who tell you not to read them; or those who won’t give you copies of the documents they want you to sign.

Avoid lenders who promise one set of terms when you apply, and give you another set of terms to sign; or who ask you to sign blank forms, saying they'll fill in the blanks later.

Don’t let anyone pressure you into using your home as collateral to borrow money you may not be able to repay. If you can't make the payments, you could lose your home.

By Mike Hamel
Published: 5/31/2006