Getting a Home Equity Loan to Pay Debt

A home equity loan is a loan that is secured by your home. Such loans may be in addition to other loans you have against your home, or, if you own your home free and clear of debt. There are two basic types of equity loans. Standard loans refer to loans that give you a lump sum amount at the beginning of the loan. They are repaid over a specific period of time, and, at the end of that time, your balance is zero. They are generally at a fixed interest rate and are sometimes called “second mortgages.” The other type of home equity loan is a credit line. Most credit lines have a variable or adjustable interest rate, and they operate similarly to a credit card. The amount you are authorized to borrow is like the limit on a credit card. You can borrow as much or as little of that amount as you wish during the “draw period.” Credit line loans often have “interest only” payments that are very low. But if you are paying interest only, then at the end of the loan period the amount owed will be the total amount of the funds you borrowed, unless you have paid additional payments toward the principle. There are big differences between these two types of loans. The home equity credit line is so much riskier than the standard loan that lenders are required by the federal Truth in Lending Act to give applicants an information booklet entitled “When your home is on the line, what you should know about home equity lines of credit.” This should be read carefully to understand the risks involved with line of credit loan.

Pros

  • In most cases, interest payments for your home equity mortgage on your primary residence are tax deductible.
  • It may be easier to get a home equity loan because the repayment of the loan is secured by your home.
  • The payments may be low because the debt extends over a long term, or because your payment may be interest only for a period of time, after which your payments may increase greatly.
  • Loans that are secured by property usually have a lower interest rate than unsecured loans.
  • A credit line loan allows you to draw upon it when the need arises without going through a loan approval process.
  • Many home equity loans are available with no closing costs.

Cons

  • If you pay only the required payment on your equity line each month at the end of the loan you can end up owing an amount close to the original amount of the loan.
  • Any closing costs for the home equity loan that are added to the loan amount will cost more in interest paid, and it will take you longer to repay the loan.
  • Your credit score will be affected due to the added debt.
  • If the value of your home goes down, you may end up owing more on your home than what you can get if you sell it.
  • A credit line loan often has an adjustable interest rate that can increase your payments greatly over the term of the loan.
  • The home equity credit line is very similar to having a credit card with an enormous limit. Therefore credit line loans make it very easy to overspend or use credit for things better saved for.
  • Transferring your credit card debt and car payments to a home equity line may lower your monthly payment, but the debt is now secured by your home.
  • Qualifying for a certain loan amount does not necessarily mean that you can afford it.
  • If you are not able to repay the home equity loan for any reason such that you fall behind in your payments, you risk losing your home.

What to Avoid

  • Avoid lenders who want you to make a quick decision.
  • Avoid loans with high late fees, annual fees, and prepayment penalties.
  • Avoid borrowing more than your home is worth or more than you need. Some aggressive lenders get a “padded” appraisal for the amount they need in order to make the loan. Be aware that such appraisals are not a true reflection of the price for which you could sell your home.
  • Avoid agreeing to loan insurance without first consulting a qualified insurance agent who may be able to obtain the same coverage for less and not have it tied to your home loan.

What to Look for

  • Apply to at least 3 different lenders and get a good faith estimate quote from each for the cost of getting the loan. Compare the three quotes and ask questions. Get a qualified professional that is not associated with the lender to explain all of the terms to you.
  • Have the lender explain adjustable rates, how they work, and what your payment will be at the maximum rate.
  • If you chose a home equity line of credit, make sure your budget allows you to pay far more than the “interest only” payment.
  • Remember you have three days to change your mind after signing loan papers involving the refinance of your primary residence.
  • Make sure you understand how a “balloon feature” works, whether it is right for your situation and what your options will be when the balance comes due.
  • Shop and compare interest rates.
  • Find out if there is a minimum amount you are required to borrow under a credit line loan.

Potential Impact on Your Credit

Paying your home equity loan as agreed is a positive on your credit but struggling with a new home equity loan and being late on payments will have a negative effect. Having zero or very low balances on your credit cards will have a positive effect on your credit.