Drawbacks of Home Equity Loans

Taking out a home equity loan against the value of your property can backfire if you fail to avoid these common pitfalls in the borrowing process.
When you need a quick source of funds, a home equity loan can be tempting. Done wisely, you can use the lower-interest debt secured by your house to pay off debts with high interest rates, like credit cards. It's also a good choice if you know exactly how much you need to borrow for a big expenditure like a vacation home or a new kitchen.

Often you can even write off the interest you pay on the loan. Consult a tax adviser. But home equity loans aren't always the best choice for accessing cash. The fact that you're staking your home against your ability to pay off the debt is just the beginning of the potential drawbacks.

Money doesn't come cheap
A home equity loan is a second mortgage on your house. Interest rates are usually much lower for a home equity loan than for unsecured debt like personal loans and credit cards. But transaction and closing costs, similar to those for primary mortgages, make home equity loans a pricey way to finance something you may want but don't absolutely need, like a fur coat, exotic vacation, or Ferrari. The average closing costs on a $200,000 mortgage are $2,732.

To compare offers on competing home equity loans, look at the annual percentage rates. These take into account closing costs and fees. On a $30,000 second mortgage, you'll save $210 a year with a 5.5% APR vs. a 6.2% rate. Keep in mind that lenders might be willing to waive some upfront costs and fees, especially if you already have your first mortgage with them, which will reduce the APR.

Early payoff can be costly
Home equity loans almost always have fixed interest rates. Although that can bring peace of mind, if you borrow when rates are high, you may find it's expensive to try to refinance to a better rate later on. That's because lenders make money when you pay back the interest on a loan. And since some lenders are absorbing the upfront costs, they make it up on the back end by charging a prepayment penalty if you refinance or sell your home.

Such early-termination fees are typically a percentage of the outstanding balance, such as 2%, or a certain number of months' worth of interest, such as six months. They're triggered if you pay off part or all of a loan within a certain time frame, typically three years. Despite the penalty, it may be worthwhile to refinance if you can lower interest rates sufficiently.

By refinancing a $30,000 loan you took out two years ago at 9% down to 8%, you'll break even in six years and nine months. This assumes both loans have 15-year terms, and you'll pay $3,000 in closing and early-termination costs. Refinance at 7% and you'll recover those costs in four years and nine months.

If you need money during a period of high interest rates, but expect rates to fall soon, it may make sense to go for a home equity line of credit instead of a lump-sum second mortgage. Although more lenders are charging stiff prepayment penalties for HELOCs too, these are triggered when the line is closed within a certain period, such as three years, not when the balance is paid off. Bear in mind that interest rates on most HELOCs are variable.

Beware predatory lenders
Some lenders don't act in your best interest. Theoretically, lenders are supposed to follow underwriting guidelines on appropriate debt and income levels to keep you from spending more than you can afford on a loan. But in practice, some unscrupulous lenders bend or ignore these rules.

Others urge you to take out up to 125% of your home's value, a practice that puts you at risk of foreclosure should you lose your job or your home fall in value. Still others work with shady home-improvement contractors who pressure you into taking their loans at above-market rates-and jack up the price if you don't. According to the U.S. Department of Housing and Urban Development, you should avoid anyone who insists on only working with one lender or who encourages you to do things like overstate your income.

Your house is at stake
A home equity loan is a lien on your house that usually takes second place to the primary mortgage. As such, home equity lenders can be left with nothing if a house sells for less than what's owed on the first mortgage. To recoup losses, secondary lenders will sometimes refuse to sign off on short sales unless they're paid all or part of what they're owed.

Moreover, even though they lose their secured interest in the house should it go to foreclosure, they can send debt collectors after you for the balance, and report the loss to credit agencies. This black mark on your credit score can hurt your ability to borrow for years to come.

June Fletcher is a real-estate columnist for WSJ.com, the online version of the Wall Street Journal, and author of "House Poor: How to Buy and Sell Your Home Come Bubble or Bust." A graduate of Princeton and Oxford universities, sheís written about housing for more than three decades.