Home Equity Loan Problems to Avoid

So, you think it's finally time to tap into your home equity. After all, it's just sitting there and you have plans for it, right? However, using your home as collateral shouldn't be a quick decision to make and the lender feels the same way. Getting a home equity loan is not as easy as proving you have sufficient equity and signing a document or two.

If you are serious about applying for a home equity loan, here are some problems and solutions to make sure you get to sign on the dotted line:

PROBLEM: You don't have enough income documentation

Lenders adore borrowers with income that is set on a regular basis and who have all the lovely paperwork that proves it. Unfortunately, if you're self-employed, work on a commission basis, or even worse, work as a freelancer with no proof you'll ever get work again, it's going to get bumpy really fast.

SOLUTION: Come prepared with at least 2 years of tax returns ready to hand over.

Avoid the pitfall: Unless you have a steady job and paycheck, expect to be asked for extra income documentation. A borrower with atypical income sources should expect to show two years of tax returns. Gather all the income verification you can and have it ready to give to your lender.

PROBLEM: Payment hikes out of nowhere.

When the housing bubble was booming, a lot of homeowners applied for and received home equity loans or refinance loans. Unfortunately, many of them ended up in foreclosure. Loans with low "It's too good to be true" interest rates that attracted many homeowners and balloon payments with fine print that no one but a lawyer could decipher all contributed to the problem.

SOLUTION: Make sure you understand all the terms.

Ask many questions and have the lender describe scenarios to you that include how your home equity loan would be affected. Would each payment be the same until the loan is paid off? What if you pay it off early...would you be penalized? What are the circumstances that would make interest rates or your payments increase? Finally, ask them up front...over the life of this loan what will it actually cost you to pay it back?

PROBLEM: Allowing someone who stands to profit from you talk you into a loan

Steer clear of a contractor or other professional who is pushing you to take out a loan or steering you toward a specific lender. What about those sweet deals where the contractor offers his own financing? Nope.

SOLUTION: It doesn't matter what you need the money for, be smart and always shop lenders. Get estimates from unions, brokers and banks.

Just like you would do with anything else you shop for, make the time to find the best rate, the most trustworthy lender, and the best payback terms.

PROBLEM: Not defining a payoff strategy and/or contingency plan

Are you relying on a future inheritance or large commission to pay off the loan? Maybe you have a good investment going and are planning on paying it back with the returns. What if it doesn't happen? Are you willing to risk your home?

SOLUTION: Anytime you borrow money no matter what it is for, always have a repayment plan.

If your plan is to repay the loan after you sell the house, the question then becomes...how long do you need to stay in the home to cover your closing costs? What if you have to sell the home at a loss? Have a solid plan in place before taking out a loan.