The Equity Pitfall

So, I get a lot of junk mail advertising passed through my door slot, dropping on my sunny front hall rug, some offering home equity loans. A home equity loan, the mailing says, can solve all my financial woes. It can pay off my credit cards, finance a home remodel, fund education, and buy that new car. My Toyota just passed the 200,000-mile threshold, so I’m anxious. What is a home equity pitfall?

With some loans, I can afford a Caribbean cruise, not something on my bucket list, but I get the idea. I would genuinely like three vacations this year. Is that asking too much? Since I’m a homeowner, I hear it all the time, pitches to sell me a home equity loan. But are all the claims valid?

The mailing makes me feel stupid if I don’t go for one. It doesn’t tell me I’m stupid, but who doesn’t want all that stuff? Well, stupid people don’t, I guess.

What home equity pitfalls will I run into when I borrow?

Why Home Equity is such an Attractive Solution

The ease of borrowing on your home equity, the money I’ve paid against my home mortgage balance, makes a home equity loan sound like a convenient way to do so much!

Problems with home equity financing are in the terms — the mortgage length, the interest rate, the application and closing fees, and more. This is the first equity pitfall. I must investigate further because of the apparent risk in borrowing against my home.

The upside of home equity is that you borrow from yourself!

What’s Home Equity Used For?

If a home equity loan isn’t designed to finance home improvements, it’s still the best reason to get one. The upside is tremendous. My home will increase in value. I won’t borrow money and start paying interest on the repair. So my home value goes up without denting my financial picture. And in the long run, it should increase the value of my home.

All I have to do is pay back the loan. The home equity loan system has worked, in that scenario.

In the Cruise scenario, It’s less of a money maker for me if I borrow and pay for a Carribean cruise. To go on a Carribean Cruise doesn’t increase my net worth like a home remodeling. Considering the depreciation rate of autos, it’s the same with buying a new car.

On the other hand, paying off credit cards and other debt is attractive. The difference between the interest rates is considerable.

If I borrow to finance a home remodeling project, I’ll be sure to calculate how much my home goes up in value. Some projects increase my home’s value more than others. If I choose wisely, a home remodel is not an equity pitfall.

How Does Home Equity Work?

When I bought my home and took out a mortgage, I started paying against the principal due and the low interest. The home’s appreciation over twenty years offset the fact that my mortgage interest was front-loaded. A lot of my home is paid off, because I’m twenty years into a thirty-year mortgage.

If I subtract what I’ve paid from what I still owe, I have the house’s equity amount. For instance, if I had paid cash for my home at the start (I didn’t), the amount of equity in my home would equal the home’s market value. Banks offer loans using my home as collateral. They charge an interest rate based on my credit rating, the home’s value, and how much I owe. When I borrow a sum from my home, the bank will often roll the loan into the amount I’m already paying. I’ll have a new mortgage payment amount every month.

This is where things get sticky because I have a low fixed rate on my original loan.

I will pay two monthly loans if I finance with a different financial institution than the original lender. As with any loan, there’s risk. I could lose my home if I default on the payment. This home equity loan picture is already getting serious, not one to take lightly.

Home Equity Lines of Credit

Home equity loans can be expensive. As I said, if I’m enjoying a low interest rate with my original loan. A home equity loan will amend the interest rate again with the new loan. I could be stuck with a higher interest rate. This is an equity pitfall.

A less expensive loan system might be a home equity line of credit if the price of credit is low. Line of credit interest is usually an adjustable rate, and if the interest rate is low, I would be better off with a line of credit than a home equity loan. At this moment, when interest rates are high, a HELOC is higher than a home equity loan.

A Banker’s decision to offer me a HELOC and the rate I’ll pay is determined by the home’s value, credit history, and the amount owed on the house. Of course, the bank will inspect the property. So, to my satisfaction, I’ll have to do an inspection myself before I ever apply.

So What is an Equity Pitfall?

Despite all that, I’m still game, but I’ve only begun the investigation. What’s ahead, in terms of pitfalls?

Paying too high an interest rate

With exit fees, processing fees, and closing fees, I’m already paying before I sign for the new mortgage. While this may be alienating, I could watch my interest rate rise if I signed up for an adjustable home equity loan. Once the deal is done, I’ll see your payment double and even go larger than that, and suddenly I’m in a spiraling debt cycle that threatens to go out of control, and my home is on the line.

And if I used my home equity loan to pay for impulse buying or paying for stuff I could have managed to buy with good budget practice, I don’t have a second chance to use my equity down the road.

So the pitfall is deciding to use my equity to solve one problem and not having it available for future problems. Regardless of how I handled a home equity loan, I will be further in debt than before I took the loan out.

Unless I’m using my home equity funds to pay off other loans, an equity loan also reduces my ability to pay off my other debts.

borrowing against your home

Your lender probably won’t point out to me the obvious, but the truth is that my home is not an investment. Not until I sell the house to move on or to sell it and retire. Until then, my primary residence is my home (get out the violins). It’s a risky proposition to borrow against it. If I cannot pay it off for some reason, I could find my credit score plunging and my ability to use resources to solve my debt problems greatly restricted.

I only say this because convenient or easy loans are not always the way to go; they’re just the easy way to go. The more difficult lesson might be to pay off my debts, especially high-interest cards and the ilk, with something other than home equity funds. Maybe a gig job. By confronting what I want the funds for, I may realize that risking my home to go on a Caribbean vacation or to buy a new car is not the wisest use of my equity. It might make more sense to pay off my existing mortgage sooner and save for other things.

But convenient loans make sense at times. I’ll apply for a home equity loan and finance the new addition to the house. But I must watch my financial picture like a hawk and pay it off quickly. The less debt I carry, the less risk to me. With diligence, I can avoid an equity pitfall.

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