4 Ways Home Equity Loans Can Sink Your Finances

Remember the real estate boom-and-bust that left many homeowners in foreclosure? Whew, glad that’s behind us, right?

If you’re like some homeowners, you’ve greeted the U.S. economic upturn by seeking out a home equity loan — basically, a type of second mortgage, but not to be confused with a home equity line of credit, or HELOC. What’s not to like about a lump sum of cash, right?

Well, one thing could be that you’re unwittingly setting yourself up to fail and, yes, face foreclosure. Still, home equity loans can make sense, as long as you’re cautious.

First, let’s talk basics. A home equity loan allows the borrower to obtain a lump sum of cash, usually at a fixed rate — averaging 5.22 percent as of late March, according to according to Bankrate.

And with the staggering average costs of home renovations — $18,000 for a bathroom remodel and $60,000 for a kitchen remodel, according to Hanley Wood Media — some owners have no choice but to borrow against equity to maintain their homes.

Mortgage debt is often thought of as “good debt,” and it often comes with tax advantages, such as tax-deductible interest. But there are a number of downsides to borrowing against your home, some of which can sink your finances.

Before you pursue a home equity loan, consider the following pitfalls.

1. Closing costs can be pricey

Prepare to pay about $4,000 for closing costs on a $200,000 mortgage, cautions Wall Street Journal columnist June Fletcher, writing for the National Association of Realtors’ HouseLogic website.

That cost could make sense if you are paying for home improvements or college — true investments — but if the money will be spent on extravagances such as a flashy car or exotic vacation, rethink it.

Even when you can afford the costs, Fletcher recommends asking your current mortgage lender if it offers any discounts on home equity loans if you use the same lender for both debts. And, certainly, shop around for the best closing costs and interest rates.

2. You risk foreclosure or the wrath of debt collectors

If you default on a home equity loan, the lender may or may not pursue foreclosure, explains legal site Nolo.

But even if you’re able to keep your home, some states allow debt collectors to go after you for the balance and report it to credit rating agencies, says Fletcher. Of course, this activity will add a black mark to your credit history.

3. Future financial options are limited

Those who obtain second mortgages have little chance of obtaining extra financing in case of emergencies, notes TheTruthAboutMortgage.com, a blog written by a former account executive for a wholesale mortgage lender in Los Angeles.

Few people expect to encounter legal or employment problems, but those who do will have few financial options if they’ve already taken out a second mortgage.

4. Unethical lenders may gouge you

Let’s say you really do want to use a home equity loan for home improvements.

Some home-improvement contractors may suggest financing options. But beware, cautions Fletcher.

Lenders are supposed to follow guidelines to make sure your income can support your debt. Do not be pressured into signing with any lender before you shop around and determine the lender’s credibility. And, of course, don’t agree to overstate your income or otherwise be dishonest.

Do you have any experience with home equity loans? Share with us in comments below or on our Facebook page.