Home Equity Loans

A home equity loan can be one of the most useful bankruptcy alternatives due to its flexibility and tax-friendly consequences. However, it is also one of the riskiest because you must put up your house as collateral. That means that the lender places a lien on your real estate, meaning the lender can foreclose on your home if you fall behind on your monthly mortgage payments.

Bankruptcy - Home Equity

The Risk Involved

It’s also important to note that the creditor can foreclose on your home even if it’s not a first mortgage holder. In other words, a creditor who holds a second mortgage or home equity loan can foreclose on your home even if you are current on your first mortgage payments.

The decision to obtain a home equity loan must be taken very seriously because of the risk involved. Even people with steady and reliable incomes may find themselves in a position in which they either desperately need the equity in their house, or cannot afford the monthly payments anymore because of a job loss or an unforeseeable change in circumstances. Once you have used the equity in your home to pay off your debts, you can no longer rid yourselves of those debts in bankruptcy. What’s more, you will not be able to eliminate your home equity loan in a bankruptcy proceeding without surrendering your house.

Be Careful of the Home Equity Trap

For many people, getting a home equity loan does not address the roots of their financial difficulties, and the new loan simply gives them more credit. More credit is not always a good thing, especially if you have not prepared a feasible budget. Many people find themselves running up even more debt on the credit cards that were paid off with the home equity loan proceeds, and quickly find themselves juggling those credit card debts and the home equity loan.

Home equity loans often appear to be an attractive option because of the relatively low monthly payments that the lender can offer. The interest rates offered on home equity loans are typically lower than interest rates associated with other unsecured loans because there is less risk to a home equity lender with a lien on your house. The home equity lender can easily force a foreclosure if you default on the loan. Moreover, even though the monthly payment on a home equity loan is typically low, the term of the loan is usually so long that the total amount paid back on the loan ends up being significantly more than the amount originally borrowed.

The Pros and Cons of Home Equity Loans

Pros

One Creditor, One Monthly Payment
Consolidating all your debts into one home equity loan may simplify the process of organizing and paying your debt back because there is only one creditor to pay.
Lower Monthly Payments
Typically, the payments on a $20,000 home equity loan will be significantly less than the monthly minimum payments required on $20,000 in credit card debt.
Lower Interest Rates
Interest rates are lower on home equity loans than on most credit cards because the creditor is taking less of a risk by requiring you to pledge your house as collateral.
Flexibility
A home equity loan typically allows you to use the money that you borrow in any way you see fit, whether it is to alleviate your debts, fund an emergency, pay for college, or make a large purchase. Although you generally have the ability to apply the proceeds of the loan to whatever debt you choose, some home equity loans do require that a portion of the proceeds pay off specific debts.
Tax Friendly
Interest on most home equity loans is tax-deductible
Cons
Potential Loss of Your Home
If you fall behind on your payments, you could lose your home.
Decrease in Your Home Equity
Once the equity is tied up in a home equity loan, it cannot be used again for emergencies, college, retirement, home repairs, or any other unforeseen financial need.
Good Credit Required for Best Interest Rates
If you have a lot of debt and your credit is not perfect, you probably will only be able to obtain a home equity loan with higher interest rates.
Closing Costs and Fees
Most home equity loans require payment of closing costs and fees that results in even more debt you must pay back to the lender.
Long Term Commitments
Home equity loans typically have 5-15 year terms. The interest accumulated over such a long period of time can grow very large even with a low interest rate.
Danger of Owing More Than the House is Worth
Should you get a home equity loan, you could find yourself in a very bad situation if the value of your home decreases over the period of the loan, or if the lender loans you more than the house is actually worth. (Make sure to get a second opinion on the value of your home before getting a home equity loan. It can be in the mortgage broker’s best interests to value your home at more than it is really worth to get the loan to close, and the appraisals they obtain can falsely inflate the value of your house.)
Things Might Change
A variety of circumstances can change that could prevent you from paying back the home equity loan. These include loss of job, divorce, an unforeseen increase in other expenses, and illness. You must be absolutely sure that your finances are steady and reliable before obtaining a home equity loan because foreclosure can be the consequence of not paying back the loan according to the terms of the agreement.
Rising Interest Rates
In recent years, many consumers have taken advantage of historically low interest rates and obtained home equity loans using adjustable rate mortgages (ARM’s), loans in which the monthly mortgage payment may change in accordance with prevailing interest rates. As interest rates increase, many homeowners are finding it difficult to avoid default due to substantial increases in their monthly payments.
Bankruptcy Tip
Beware of paying off your car or any other asset loan using a home equity loan. Doing so will create the kind of asset that may present complications if you later choose to file a Chapter 7 Bankruptcy. (Complete Free Legal Evaluation for complete information from a qualified bankruptcy attorney)

Consider A Home Equity Loan If…

  • Your home’s fair market value is greater than the total outstanding loans and mortgages owed on the house.
  • Your job or other source of income is stable.
  • You are not counting on your home’s equity for other purposes (payment of college tuition, retirement, repairs, emergency funds, medical expenses, etc.)
  • Your credit is good enough that you can obtain a home equity loan at a decent interest rate.
  • You have a long-term budget in place that will allow you to pay two mortgages and will not require you to use your credit cards.
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