Protect Yourself: Home Equity Do's and Don'ts

Understanding the pros and cons of any type of loan is important for avoiding scams and responsibly using home equity. In this article, we’ll review key information anyone considering a HELOC should have. We’ll also discuss how to protect yourself from common HELOC pitfalls.

Getting a home equity line of credit (HELOC) is a big step for any homeowner. If you’re thinking about a HELOC or another type of second mortgage, consider having a real estate attorney review your loan agreement. They can help you understand repayment conditions, hidden penalties/fees, and interest rate provisions. They can also be instrumental in negotiating better terms for you and ensuring your interests are protected.

Let’s start with the basics about HELOCS and how one can work for you.

What Is a HELOC?

A HELOC, or home equity line of credit, is a type of mortgage loan. It lets homeowners borrow money using the amount of equity they have in their home. Equity is the difference between your property’s value and your mortgage balance.

A HELOC works like a credit card. You get a credit line from which you can borrow during the draw period. This is usually five to 10 years. After it ends, you enter the repayment period.

Unlike a home equity loan, where you get a lump-sum payment, HELOCs let you borrow funds as needed. You’ll only pay interest on the money you use, not the full loan amount.

Pros of a HELOC

HELOCS are often used for home improvement, personal finance needs, or to pay off higher-interest-rate debts like credit cards or personal loans. HELOCs can work for homeowners because they offer several beneficial features. These include:

• Flexibility: You can borrow only what you need and only when you need it, which is great for ongoing expenses like renovations
• Lower interest rates: HELOCs tend to have lower interest rates than credit cards or unsecured loans because they’re backed by your home
• Tax benefits: The interest you pay on a HELOC may be tax-deductible, but only if the borrowed funds are used to buy, build, or substantially improve the home securing the loan (interest on HELOC funds used for other purposes is generally not deductible under current U.S. tax law)
• Versatility: You can use a HELOC for almost anything, including your down payment on an investment property/second home purchase or something completely unrelated

If a HELOC sounds too good to be true, it might be. Whether it’s the right option for you will depend on your circumstances. Let’s take a moment to explain and consider its disadvantages as well.

Cons of a HELOC

Like any mortgage loan, a HELOC has its downsides. These include the following:

• Risk of foreclosure: Because your home is used as collateral, failing to make monthly payments can lead to foreclosure
• Variable interest rates: Many HELOCs have variable interest rates, which means your payments can go up if interest rates rise
• Fees and costs: You typically have application fees, closing costs, and other charges similar to your first mortgage
• Temptation to overspend: Access to a large credit line can lead to poor personal finance decisions for some people

Every situation is different, and so is every person who gets a HELOC. Because it’s a loan, it’s natural to wonder if a history of credit issues might cause problems getting a HELOC. Let’s take a look.

Getting a HELOC With Bad Credit

Even with a low credit score, you might still qualify for a HELOC. That’s great, but you’ll likely face higher interest rates and stricter terms. In addition, your loan-to-value (LTV), which is the ratio of the loan amount to your home’s value, might be lower than for someone with excellent credit. That means you might not be able to borrow as much as someone with good credit can.

Don’t be afraid to explore options to find the best HELOC available to you. Here are some tips:

• Check your credit report: Your credit score plays a significant role in determining your interest rate and loan terms
• Improve your debt-to-income ratio: By paying down debts, you’ll likely improve your credit score and show that you can manage monthly payments
• Shop around: Some lenders specialize in working with people who have poor credit, so compare terms and rates from multiple lenders to find the best deal
• Use a co-signer: If you have a co-signer with good credit, you may be able to qualify for a better interest rate

If you still can’t get a HELOC, or feel like the terms won’t work given your current mortgage payments, other financing options may be available. Consider discussing the terms of a cash-out refinance, home equity loan, or reverse mortgage with your attorney advisor. If you don’t need access to funds, refinancing might be another option to lower your payments/interest rate or change the terms of your primary mortgage.

If you still plan to proceed with a HELOC, you’ll need to understand a few things about credit insurance. Let’s see what it’s all about.

Credit Insurance

Credit insurance, also called debt protection, is optional coverage that pays off your HELOC if you become unable to work due to disability, unemployment, or death. Many lenders offer it when you apply for a HELOC.

While it sounds helpful, credit insurance is often expensive and may not provide the coverage you expect. In addition, you may already have better coverage through your life or disability insurance policies.

Some lenders will automatically include credit insurance in your HELOC agreement. Be cautious about these and other automatic add‑ons. Review the terms carefully and opt out if you don’t want the insurance.

Tips for HELOC-Funded Renovations

Using a HELOC for home renovations often makes sense if they add value to your home, but not all renovations do. While a new kitchen or bathroom often provides a good return on investment, a highly personalized or overly expensive renovation might not appeal to future buyers.

Before starting any renovation, research what improvements are popular in your local housing market and which renovations are likely to increase your property’s market value. Avoid over-improving beyond your neighborhood’s housing market.

You’ll likely want to focus on projects that improve functionality, curb appeal, or energy efficiency. A well-planned renovation funded by a HELOC can increase the value of your home, but only if done wisely.

Avoiding Home Improvement Scams

There will always be thieves looking to take advantage of people seeking loans. If you’re using a HELOC to fund a renovation, beware of scams.

As more homeowners tap into their equity for renovations, contractor-lender collusion is becoming increasingly common. It usually involves contractors actively referring homeowners to specific lenders, who are part of the scam.

These lenders approve the loans quickly with seemingly reasonable terms. At signing, however, the terms may suddenly change. Interest rates spike, fees appear, and pressure tactics are used. In these scams, homeowners often feel trapped because the contractor is already expecting payment.

Maintain awareness of these and other scams with the following tips:

• Get multiple contractor quotes: Obtain at least three detailed bids for your project
• Check references and reviews: Look for contractors with a good reputation and positive feedback from past clients
• Verify licenses and insurance: Ensure the contractor is properly licensed and insured
• Get everything in writing: A detailed contract should outline the scope of work, materials to be used, timeline, payment schedule, and warranty information
• Avoid large upfront payments: Be wary of contractors who demand a larger-than-normal down payment (10-30% in many areas) before work begins
• Inspect work as it progresses: Regularly check the quality of the work throughout the project and address any concerns immediately

By staying informed and cautious, homeowners can successfully use a HELOC to improve their homes and financial situations. Continue to practice due diligence when it comes to selecting your lender.

Choosing the Right Lender

As you likely know, not all lenders are the same. Picking the right one is key to getting good terms that fit your needs.

To that end:

• Research credit unions and online lenders, in addition to traditional banks
• Look for transparent fee structures, competitive interest rates, and clear explanations of terms
• Consider factors like customer service and application processing times
• Read reviews from other homeowners
• Ask about penalties for early repayment
• Find out which lenders, if any, offer fixed interest rate options
• Pay close attention to closing costs, automatic add-ons, and hidden fees

Remember, you’ll be working with this lender for years. Choose one with clear disclosures and helpful support.

Speak With a Lawyer

If you’re considering a HELOC, be aware that your home is the collateral for the loan. If you default, you could lose your house. Proceed with caution and minimize risks whenever possible. A solid real estate attorney can be key to avoiding HELOC surprises before it’s too late.

If needed, an attorney can also help you enforce your right to rescind a HELOC contract you’ve already signed. Under federal law, this must be exercised within three business days. State laws may offer additional protections.

Wherever you are in the process, an attorney licensed in your state can help you understand your options and protect your interests in what is often a predatory environment.

Make sure you use a trusted resource like FindLaw’s directory of real estate attorneys or their directory of consumer protection attorneys. You can review ratings and background information for specialized advisors in your area by clicking on your state, then city.

The stakes are high when your home is on the line, and informed decisions are critical at this time. Give yourself some peace of mind and enlist the help of an advocate.