Don’t make these 5 home equity loan mistakes

You can tap into your equity with a home equity loan or a home equity line of credit (HELOC) to finance renovations, consolidate debt, or pay for other large expenses.

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One of the mightiest benefits of homeownership is the opportunity to build wealth. As you pay down your mortgage each month, you build equity — the amount of your home that you own outright. Home equity also changes (for better or worse) as the housing market fluctuates: As home values rise, so can home equity, and vice versa.

To calculate home equity, subtract the amount you owe from your home’s current value. For example, if your home’s value is $300,000 and you have $200,000 remaining on your mortgage, you have $100,000 in home equity.

You can tap into your equity with a home equity loan or a home equity line of credit (HELOC) to finance renovations, consolidate debt, or pay for other large expenses. However, your house serves as collateral, so it’s essential to avoid any missteps that could cost you more money — or your home. Here are five potential home equity loan mistakes and how to avoid them.

Home equity loan mistakes to avoid

Here are five mistakes to avoid when borrowing against your home’s value.

1. Borrowing more than you need

You can use a home equity loan for virtually anything, but it’s best to focus on things that add to your home’s value or improve your financial situation. While it can be tempting to borrow more than you need (say, to pay for that vacation you’ve been dreaming about), remember that the larger your loan, the higher your monthly payment — and the more interest you’ll pay over the life of the loan.

Borrowing more than you need can strain your budget unnecessarily and make it harder to reach your other financial goals. For this reason, think carefully about how you’ll use the money and how much cash you actually need before taking out a home equity loan.

TIP: The Inflation Reduction Act of 2022 lets you claim federal tax credits for making energy-efficient home improvements, such as installing eco-friendly heat pumps, water heaters, insulation, exterior doors, windows, and skylights. The tax credit is worth up to $3,200 a year through 2032, with no lifetime dollar limit — meaning you can claim the maximum credit every year that you make eligible improvements.

2. Applying when your credit score is low

You can get a home equity loan with a less-than-perfect credit score, but you’ll likely pay a higher rate — leading to larger monthly payments and higher total interest costs. Consider taking steps to improve your credit score before applying for a loan. Be sure to pay your bills on time, pay down your revolving credit balances, keep your credit utilization low, check your credit report, and fix any errors.

TIP: Consumers can request a free credit report at AnnualCreditReport.com every 12 months from the three major consumer reporting agencies. Review your report carefully, looking for incomplete or inaccurate information. If you find an error, contact the credit reporting agency that sent you the report and the company that provided the information (visit the Consumer Financial Protection Bureau’s website for more help).

3. Taking the first offer

Lenders offer different rates, terms, and fees, and the first offer you receive may not be the best.

Your interest rate and loan term impact your monthly payment and the total cost of the loan:

The higher the interest rate, the bigger your monthly payment and the more interest you pay over the life of the loan, and vice versa.
The longer the loan term, the smaller your monthly payment and the more interest you pay over time, and vice versa.

Closing costs vary, too, and typically range between 2% and 5% of the total loan amount—or between $1,000 and $2,500 on the same $50,000 loan. The best home equity loans can save you thousands of dollars in interest and fees over the life of the loan, so it pays to shop around before making any decisions.

4. Underestimating the risks

A home equity loan is a type of second mortgage, meaning you’ll have two monthly mortgage payments instead of just one. If you fall behind on payments for either loan, you can damage your credit score, making it more challenging (and expensive) to get other loans and credit lines in the future. More importantly, defaulting on either loan puts you at risk of losing your home to foreclosure.

Crunch the numbers to ensure you can comfortably afford both mortgage payments. It’s wise to have an emergency fund that covers at least three to six months of living expenses (including both mortgage payments) just in case you lose your job or have unexpected expenses. That way, you’re less likely to hurt your credit or risk foreclosure if a financial emergency arises.

5. Not understanding fixed vs. variable interest rates

Home equity loans usually have fixed interest rates, which means you have predictable monthly payments for the life of the loan. On the other hand, HELOCs typically have variable rates, so your monthly payment can change throughout the repayment period. If interest rates rise, your payments will increase, which could make it harder to balance your monthly budget.

If you’re considering a HELOC, be sure you can afford to make larger monthly payments if interest rates rise. If not, a home equity loan might be safer since you can lock in a predictable payment for the entire loan term.

Bottom line

A home equity loan can be an excellent way to fund improvements, consolidate debt, and pay for other significant expenses.

Still, remember that your home is on the line, and you could lose it to foreclosure if you fall behind on payments and default on the loan. For this reason, home equity loans should never be used for speculative purposes (e.g., a risky investment) or to fund a lifestyle your income can’t support. Instead, using a home equity loan to invest in your future and improve your overall financial situation is best.

HELOC and Home Equity Loan FAQs

What are good home equity loan rates?

The best home equity loan rates can vary by lender. The average national rate for a home equity loan in August 2023 was between 7.97% and 9.84%. To find the most competitive rates, it’s best to do your research and shop around for the right lender for your needs.

What are the best HELOC rates?

As of August 2023, the average national rate for a home equity line of credit (HELOC) is between 7.70% and 9.71%. To get the best HELOC rates you will need to have a good credit score, a low debt-to-income ratio, a high enough income, and a reliable payment history. Even if all of these factors apply to you, it’s important to get quotes from at least a few lenders.

A HELOC is a revolving line of credit, which makes it similar to using a credit card. HELOCs usually come with a draw period of 10 years, followed by a repayment period. During the draw period, you can access funds as needed and repay only the interest as you go. Each time you make a payment, your credit line will replenish. During the repayment period, you’ll make larger payments that include both principal and interest. HELOCs tend to come with variable interest rates, but some lenders offer fixed payment options. A HELOC is a great option if you’re not sure how much you’ll need to borrow.

What is a fixed-rate HELOC?

A fixed-rate HELOC is considered a hybrid product because it combines a home equity loan’s fixed interest rate with a HELOC’s credit line. You can withdraw money (up to your credit limit) just like you would with a traditional HELOC. But unlike a variable HELOC, you lock in all or a portion of your balance at a fixed interest rate during the draw period. This can make it easier to plan and budget while protecting you from future interest rate hikes.

What is the best HELOC strategy?

Just because you can use a HELOC for anything doesn’t mean you should. After all, your house is on the line, and you risk losing it to foreclosure if you default on the payments. For this reason, the best HELOC strategy is to use the HELOC to boost your home’s value or strengthen your financial situation in some other way.

Is HELOC interest tax deductible?

The interest you pay on a HELOC can be tax-deductible — but not always. It all depends on what you use the funds for. According to the IRS, you can only deduct the interest you pay on a home equity loan or line of credit if “the borrowed funds are used to buy, build, or substantially improve the taxpayer’s home that secures the loan.” Here’s a closer look at the nuances involved in the question of whether heloc interest is tax-deductible.

How can I increase my home’s value?

If you’re researching home equity loans and HELOCs, you’ve probably started wondering how you can increase your home’s value. Check out our guide for tips, including investing in smart energy, replacing your roof, and refinishing hardwood floors.

What is a home improvement loan?

A home improvement loan is an unsecured loan that you can use to pay for various home repairs and renovations — such as a roof replacement, furnace/HVAC repairs, kitchen or bathroom remodel, deck addition, solar panel installation or landscaping. Loan amounts range from $3,000 to $100,000, which you repay with interest in monthly installments over one to five years.

Once you’re approved for a home equity loan, your lender gives you the funds as an upfront lump sum. This makes home equity loans ideal for homeowners who want to borrow a specific amount for a major project or big one-time expense. To repay the loan, you make fixed monthly payments (with interest, of course) over a set term ranging from five to 30 years.

TIP: Remember that home equity loan payments are in addition to your usual mortgage payments, so budget accordingly. If you default on the loan payments, your lender can foreclose on your home.

How can I get a home equity loan?

More HELOC & Home Equity Tips

Calculate how much equity you have in your home.
Decide how much you need to borrow.
Compare borrowing limits, features, terms, and customer reviews across lenders.
Get quotes from a handful of lenders that meet your needs.
Choose the lender with the lowest rate offer and submit a formal application, which will require a hard credit check.
Schedule an appraisal.
Wait for approval and close on your loan.
Begin repayment.

Calculate how much equity you have in your home.
Decide how much you need to borrow.
Compare borrowing limits, features, terms, and customer reviews across lenders.
Get quotes from a handful of lenders that meet your needs.
Choose the lender with the lowest rate offer and submit a formal application, which will require a hard credit check.
Schedule an appraisal.
Wait for approval and close on your loan.
Begin repayment.

Editorial Disclosure: All articles are prepared by editorial staff and contributors. Opinions expressed therein are solely those of the editorial team and have not been reviewed or approved by any advertiser. The information, including rates and fees, presented in this article is accurate as of the date of the publish. Check the lender’s website for the most current information.

This article was originally published on SFGate.com and reviewed by Lauren Williamson, who serves as Financial and Home Services Editor for the Hearst E-Commerce team. Email her at [email protected].

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