Home Equity Loan Risks and Dangers

By: James Lamb

Home Equity Loan Basics

A home equity loan is a loan that allows a home owner to secure a loan with their home's equity as collateral. They have become very popular as property prices have soared around the world.

In lay terms, what the above paragraph means is the following...

Suppose you purchased a home for $200,000 five years ago. Suppose the current value of your home is now $300,000. Then you have made a $100,000 paper profit on your home, and this can also be called a $100,000 home equity. If you would like to spend your $100,000 home equity, it would not really be possible to sell a portion of your home. However, you would be able to secure a $100,000 loan against your equity, and this would be known as a home equity loan.

Why would someone want a Home Equity Loan?

People may seek a Home Equity Loan for a wide variety of reasons.

The most trivial uses are fairly obvious. Luxurious holidays in sun, dream cars to be enjoyed, shopping sprees aplenty.

However, the cash from home equity loans can be used for more serious applications. Sudden medical bills can arrive unexpectedly after ill luck. I recently endured a 2 week stay after suffering a collapsed lung on a mountain top. The full bill came to over $4,000! Fortunately I had medical cover. Others may not be so lucky.

The cost of education is rising as governments tighten budgets and competition for places increases. Many children of hard working families are struggling in this expensive climate, but a home equity loan could ease their troubles.

Reinvesting in property is another popular use of home equity loans, especially in the UK. They are commonly used for home improvements, so as extensions and redocorations.

Home Equity Loan Dangers

Before taking out a loan the following points should be considered. The borrower must ensure that the loan they take is suitable for them and within their financial capabilities. They should not rely on lenders to assess this. Remember that loan salesmen are there to make commission. From their point of view, what happens to the borrower after a loan has been taken out is pretty irrelevant providing there aren't any repercussions for the lender.

Only borrow what you need

Before taking out a Home Equity Loan you should consider what you want to use it for carefully. You should not take out more than you intend to spend, as interest must be paid on the full loan amount, whether you spend the money or leave it in the bank. Do not let a salesman convince you to take out an extra thousand for a shopping trip!

Get a good range of quotes

Always get a range of quotes before taking out a loan. Silver tongued salesmen are trained to convert the public into indebted borrowers. A good way to find out if they're quotes are as competitive as they say they are is to compare them to the competition.

Can you afford the repayments?

It is important to understand the size of any repayments on a loan. If you can't afford the monthly payments from your regular income then the loan probably isn't a good idea.

How long does the loan last for?

Taking out a home equity loan with a repayment period that extends into your retirement is not a good idea for obvious reasons. Make sure that you confirm this information yourself as lenders have been known to make errors. Also, not that shorter repayment periods are generally better as less interest will be paid overall. Shorter repayment periods have higher monthly repayments, but these are worthwhile as you will pay less overall.

What interest rate will you be charged?

You obviously want to get the lowest rate. It is therefore prudent to shop around and get a range of quotes from several lenders.

What are the Penalty Fees?

Penalty fees may be charged for late payments. They are often excessive and you won't want to be caught out. So read the small print! If there is a chance you'll want to repay the loan early make sure that the lender does not penalise the borrower for making overpayments.

Only use well known reputable lenders

Only borrow from reputable lenders and ensure that you know the full terms and conditions of a home equity loan before taking it out. There are so many cowboy firms out there that it just isn't worth risking your home and for the tiny savings that smaller firms may offer you. There have been recent reports of unscrupulous lenders charging exhorbitant rates of interest to uneducated individuals who do not read the small print carefully enough. A particular example involved a couple who took out a ?10,000 loan, only to see it climb to ?180,000 as they defaulted on payment after payment. So make sure that you understand your repayment obligations and can afford to pay them.

Don't bother with payment protection or insurance

At time of writing, loan repayment insurance policies are overpriced and have so many clauses that they rarely pay out. Just don't bother with them

This article is based on the author's opinion and does not constitute financial advice. The author is not liable for the results of any decisions made as a result of reading this page.

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