Home Equity Loans Explained

Home equity loans are loans that let you borrow against the equity of your home, which is used as collateral. Equity is the amount of money you have invested in your house so far. It's the difference between what your house would sell for on the open market and how much you still owe on your mortgage. If your house will sell for $150,000 and you owe $100,000 on your mortgage, then you could borrow up to $50,000.

This means you typically have to be a homeowner, although there are other ways of getting an equity loan. When considering a home equity loan, look for special interest rates and even tax incentives (talk to your tax advisor). You can use your equity loan as a home improvement loan, to pay for school tuition or whatever you like.

Always shop around when searching for any type of loan. One lender may offer you something entirely different than another. It?s your job to do the research and figure out where you can get the best deal. A tiny percentage can add up to thousands over the life of a loan.

Now, the bad news. There are some unscrupulous lenders trying to make a quick buck off of people getting home equity loans, so it?s important to understand what you are getting yourself into.

Balancing Need Versus Security

Do you own your home? If so, it's likely to be your greatest single asset. Unfortunately, once you agree to a loan that's based on the equity you have in your home, you may be putting your most valuable asset at risk.

Homeowners - particularly elderly, minority and those with low incomes or poor credit - should be careful when borrowing money based on their home equity. Why? Certain abusive or exploitative lenders target these borrowers, who unwittingly may be putting their home on the line.

The Federal Trade Commission urges you to beware of these loan practices to avoid losing your home:

Equity Stripping

You need money. You don't have much income coming in each month. You have built up equity in your home. A lender tells you that you could get a loan, even though you know your income is not enough to keep up with the monthly payments. This lender may be out to steal the equity you have built up in your home.

Here's how the scam works:

The lender encourages you to "pad" your income on your application form to help get the loan approved.

The lender doesn't care if you can't keep up with the monthly payments. As soon as you don't, the lender will foreclose - taking your home and stripping you of the equity you have spent years building.

If you take out a loan but don't have enough income to make the monthly payments, you are being set up. You probably will lose your home.

Hidden Loan Terms: The Balloon Payment
You've fallen behind in your mortgage payments and may face foreclosure. Another lender offers to save you from foreclosure by refinancing your mortgage and lowering your monthly payments. Look carefully at the loan terms.

Here's how the scam works:

The bait is that payments may be lower because the lender is offering a loan on which you repay only the interest each month.

At the end of the loan term, the principal - that is, the entire amount that you borrowed - is due in one lump sum called a balloon payment. If you can't make the balloon payment or refinance, you face foreclosure and the loss of your home.

Loan Flipping Scams

Suppose you've had your mortgage for years. The interest rate is low and the monthly payments fit nicely into your budget, but you could use some extra money. A lender calls to talk about refinancing, and using the availability of extra cash as bait, claims it's time the equity in your home started "working" for you. You agree to refinance your loan.

Here's how the scam works:

After you've made a few payments on the loan, the lender calls to offer you a bigger loan for, say, a vacation. If you accept the offer, the lender refinances your original loan and then lends you additional money. In this practice-often called "flipping" - the lender charges you high points and fees each time you refinance, and may increase your interest rate as well. If the loan has a prepayment penalty, you will have to pay that penalty each time you take out a new loan.

Loan flipping gives you some extra money and a lot more debt, stretched out over a longer time. The extra cash you receive may be less than the additional costs and fees you were charged for the refinancing. And what's worse, you are now paying interest on those extra fees charged in each refinancing. With each refinancing, you've increased your debt and probably are paying a very high price for some extra cash. After a while, if you get in over your head and can't pay, you could lose your home.