Home equity loan mistakes to avoid

With today's high inflation and challenging economic climate, you may be looking for some help covering expenses. 

If you're a homeowner, taking out a home equity loan can be one option to explore. These can be particularly helpful if you need to cover home improvements, as they could qualify you for a valuable write-off come tax season.

Are you thinking about taking out a home equity loan? Then it helps to know some costly mistakes to avoid.

Start by exploring your home equity loan options here to see if it makes sense for you.

Home equity loan mistakes to avoid

Here are four mistakes to avoid when using your home equity. 

Borrowing more than you need

Before you take out a home equity loan, it's important to know how much money you need and will actually use. For one, taking out too much can mean higher monthly payments, which could cause financial distress if you lose your job or see reduced hours.

"Borrowing more than you need increases your monthly payments and puts extra strain on your budget, potentially making it more difficult to meet your financial obligations," says Andrew Latham, a certified financial planner and editor at Super Money. "Always borrow only what you need to minimize financial risks and ensure you can comfortably repay the loan."

Taking out too big of a home equity loan can also increase your long-term interest costs. (Unlike home equity lines of credit or HELOCs, home equity loans require you to pay interest on the full amount borrowed — not just the portion of the funds used).

Applying with bad credit

You don't necessarily need a perfect credit score to get a home equity loan, but applying for one when your score is low isn't typically recommended. Not only will it make it hard to qualify for the loan, but you'll likely get a higher interest rate if you do.

"Applying for a home equity loan with bad credit can lead to higher interest rates and less favorable terms," Latham says. "It's a good idea to improve your credit score before applying for a home equity loan to secure better terms and lower interest rates."

To improve your score, pay down your credit card balances, set your bills on autopay and dispute any errors you find on your credit report. You can also ask for an increase in your credit card limits. This reduces your credit utilization rate — how much of your limit you're actually using — which can help increase your score.

Not shopping around for your loan

Any time you get a loan, credit card, or other financial product you should shop around, as lenders offer a variety of rates, terms, and fees.

"One common mistake borrowers make is not shopping around for the best rates and terms," Latham says. "Comparing different lenders can save you thousands of dollars over the life of the loan."

Shopping around is particularly important if your credit score is lower, as home equity loan requirements can vary quite a bit from one lender to the next. Start shopping around for lenders here or via the below table.

Not understanding the risks

Home equity loans come with some pretty big risks, so it's important to understand these before taking one out. 

First, they're a second mortgage — a loan in addition to your first mortgage loan. That means once you're approved, you'll have not one but two monthly mortgage payments. This can be stressful financially, and if you fail to make your payments, it could hurt your credit.

More importantly, it can also put your home in harm's way. As Susan Waite, vice president of lending at Point Breeze Credit Union, explains, "Home equity loans are secured by your home, so if you default, you could put your home at risk of foreclosure."

Home equity loan alternatives

HELOCs can often be a good alternative to home equity loans, as they work more like credit cards. You can borrow what you need, pay it back and then borrow more later. You also pay interest only on what you use.

Cash-out refinancing is another option for homeowners. With this strategy, you replace your current mortgage loan with a larger one, getting the difference back in cash. You can then use those funds however you'd like.

Finally, there are also home equity-sharing options. This is when you get a lump sum of money in exchange for sharing in your home's future sale. These require no monthly payments, though they can eat into your sales proceeds if you're not careful.

If you think a home equity loan is your best recourse then start by checking out rates and eligibility here now.