Knowing you can borrow against your home’s equity may seem like a dream come true. If you need money, you can apply for a home equity loan and have the money in hand shortly. But, should you do it? What mistakes do people make with home equity loans?
Keep reading to find out.
Ignoring Your Loan-to-Value Ratio
Just because you can tap into your home’s equity doesn’t mean you should. Know what the loan entails. Can you afford the payments? Do you know how much equity is left after you take the home equity loan? If you sell your home in the near future, you may be surprised to find out how little equity you have. That’s not a good position to be in, especially since sellers have closing costs too.
If you know you will move soon, consider what position you’re left in if you tap into the home’s equity. Most lenders only allow you to borrow up to 80% of the home’s value with a home equity loan, but find out for sure. Look at the dollar amount you’ll have left. Is it enough to sell your home and walk away with a little more money in your pocket or will you have to bring money to the closing?
Not Knowing the Loan’s Terms
Each home equity loan has its own terms. If you don’t know them, you could be in for an unpleasant surprise. For example, a HELOC (home equity line of credit), has a variable interest rate. In other words, you don’t know from one month to the next what interest rate you’ll pay. Know the terms of the interest rate and ask about the worst-case scenario. What if the rate gets so high that you can’t afford the payment?
You should also know how the loan operates. Using the HELOC example again, you can draw against the HELOC’s balance for the first 10 years. After that, the loan becomes a standard home equity loan with a fixed interest rate and required payments. You must pay off the amount you withdrew over the next 20 years.
If you take out a standard home equity loan, you may have less time to pay the loan off. Most home equity loans have a 20-year term. This means larger payments right off the bat. Can you afford the payments? It’s important to determine this ahead of time.
Missing Your Payment
Just because the home equity loan is a second loan doesn’t mean you can skip your payment. As is the case with your primary mortgage, your home is the collateral for the loan. If you miss many payments, you could find yourself facing foreclosure.
The second mortgage lender can initiate foreclosure proceedings. But, you may still find yourself on the hook for payment if the sale proceeds don’t cover the full amount of what the lender lost. This is a common scenario with second mortgages, so make sure it’s a loan that you can afford to pay back as required.
Consolidating Debt Into Your Home Equity Loan
It can be tempting to roll your consumer debt into your home equity loan. After all, your home equity just sits there unused, right? While it may seem like a good idea at the time, think about the consequences.
Consumer debt is unsecured. The creditor can’t take your home from you if you default on the payments. Mortgage debt, including home equity loans, however, is secured. Once you wrap the consumer debt into the home equity loan, your home becomes at risk.
If you are financially responsible, this may not be a big deal. But, if you go and rack your credit cards up again, you are right back where you started. In fact, you’re in a worse position since you now owe the higher home equity loan balance plus your new credit card debt. If you know you can’t leave your credit cards untouched or you can’t keep up with the home equity loan payments, don’t consolidate your consumer debt.
Making Home Upgrades that Don’t Count
Don’t assume that all home upgrades are worth it. You may not see the reflection in your home’s value that you thought. Only a select few upgrades actually reflect in the home’s value. Typically, bathroom, kitchen, and room additions add the most value. Any renovations dealing with cosmetic changes don’t increase a home’s value. Instead, they increase the home’s likeability based on personal preference.
Before you tap into your home’s equity to make home renovations, talk to a professional about the impact on your home’s value. Will it increase? How much will it increase? Then you can decide if taking money out of your home is worth it.
A home equity loan can be a great way to get the cash you need, but only after careful thought. Know the loan’s terms, your home’s value, and how the loan affects your financial future. Think about your plans and how soon you’ll sell the home before deciding to tap into your home’s equity.