Why Home Equity Loans Are a Bad Idea

I often hear people say, “We’re going to take some money out of the house” when they get a home equity loan. That is exactly what banks and lenders want you to think you are doing, but it is totally and completely wrong. Let me explain.

Think back to when you got your first home loan. A woman in a pant suit probably put on an OSHA-approved back brace to hand you the 50 pounds of papers you signed. Those papers ostensibly said that if you were unable to pay back the mortgage, the bank would take your house away from you. This you happily agreed to, because, hey, it’s a house, and owning a house is good! A few years later, your house appreciated (that’s a fancy way of saying it’s worth more), and some banker convinced you that you need to “get some of that equity out” to use on cool things, like paying for your kids’ college, or building a new deck, or putting in a pool, or something. They probably said something like, “that’s a lot of money tied up in your house doing nothing — why not take advantage of it?” If you were ignorant, this probably sounded like a good idea.

That reminds me of a story. One time I went into a bank to get a letter notarized. The kind banker asked me if, in addition to the notary service, I wanted to also get a home equity loan. I responded, “Why would I want another loan when I’m working so hard to get rid of the one I have?!” She was surprised. Apparently most people take her up on her offer.

Anyway, back to why home equity loans are stupid. Let me make a point here. There is absolutely no way, none, zilch, whatsoever, of “taking money out of your house” without selling it. Let me say that again, you cannot get money out of your house unless you sell it. Period. Don’t believe me? Keep reading.

You need to get something clear if you are considering a home equity loan. When you get such a loan, what you are saying is this: Hey, my house is worth more than when I bought it. I should get another loan, and tell the bank (again) that they can take my house away if I can’t pay this loan back. That’s it. That’s all it is. You are getting another stinking loan, which the bank is happy to give you, because if you can’t pay it back, they’re going to take your house away and pay themselves back for both loans. It really is that simple. By getting a home equity loan, you are just handing over your house as collateral in exchange for another loan. This is a fantastic way to ensure that you will be in debt for the rest of your life. The bank would love for you to get a home equity loan every time you pay back a little bit of your last loan. Banks love loans.

Now you may be thinking this: But that’s my money. I paid down that first loan, and now I want my money back. Wrong! That was never your money. That was the bank’s money to begin with, and you were paying it back to them. They’re trying to trick you into thinking that it’s your money, and you can just “get some out,” as if your house was a gigantic ATM. But it’s not an ATM, because the money you used to buy it was not your’s. It was the bank’s. Remember, you borrowed it in the first place? How are you going to “take some of your money out” if you had to borrow it in the first place?

So the next time someone tells you they’re “going to take some equity out” of their house, you should probably say, “Don’t you mean you’re going to get another loan and give your house to the bank if you can’t pay it back?” They’ll probably get sick of your smug little smirk in a hurry, but, hey, sometimes the truth hurts.

But what about the tax shelter? If I pay off my home mortgage, I won’t get tax benefits. Quick, Mr. Banker, save me from the IRS! This is another big, fat myth, but that’s another story.

21 comments to “Why Home Equity Loans Are a Bad Idea”

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  1. Your last comment reminds me of a conversation I had recently with a friend who’s been in the loan business for a while. He said that now his children are grown up and moved out, he needed something else for a tax deduction. So, he got a new “interest only” loan to sink money into just so he could count the “deduction”. He could pay it all off, but oh well, ignorance won out. If I were him I would just pay it off, and donate the money he would be paying in interest to some good cause. Those can be tax deductible too, if that’s such an important criterion.

  2. Another big no-no is paying off credit cards with money out of a HELOC.

    This is a bad idea because the CC was an unsecured debt (they can’t take away the junk you purchased if you don’t pay your CC bill) and you replace that with a secured debt. So, you may end up paying less interest on last year’s over-the-top Christmas, but if you can’t make that HELOC payment, next year’s Christmas will be spent out on the street.

  3. Charles,

    Great comment. I agree with you about the tax deduction. I like to think of it this way:

    Assume you’re in a 30% tax bracket. By getting a loan for the sole purpose of a tax deduction, with for example a $1,000 monthly interest payment, you are effectively giving the bank $1,000 each month so you can get a $300 tax discount from the IRS. That’s an expensive discount!

    If your friend would like me to do that for him, I’d be happy to take his $1,000 per month, and pay him $700 for the service. Even though he is wrong, your friend is not alone in his thinking, but there are loads of lenders who would like to convince you that he’s right.

    –Dave

  4. Good post, you are the next Dave Ramsey. ;)

  5. Dave is actually my inspiration for the tax comment above. :)

    Also, I could never fill Dave Ramsey’s shoes. I can’t pack that much “awesome” into anything like Dave does.

    Just FYI, he’ll be coming to Salt Lake in May (E-Center). My wife and I intend to buy Platinum tickets.

  6. Your holiday Gift

    I find it interesting that you have to pay a guy like Dave Ramsey to be told information that is free. What makes his idea of getting out of debt any different then the simple information that the LDS church teaches in debt management?
    It all boils down to three simple steps that are repeated over and over. 1. Self Control 2. Pay more then the minimum 3. Save. It isn’t Rocket Science.

    If you exercise self control, you don’t spend money on things that put you in debt. Don’t forget to Save!!!
    There are times that you may need to put something on credit. Have a plan to pay a quater to a half of that total debt. If you are saving then you will have the emergency fund that would be available in place of credit. If the emergency happens and your e-fund is not where it needs to be use what you have. That is why you have it right? Right!!!

    Like the saying goes. Frugality is divine, Idulgence chafe’s and binds. Nine times out of ten, it is our own selfishness that puts us in debt. A little self control goes a long way.

    Isn’t it interesting that you are willing to pay for Platinum tickets to his “Show” just to be told three simple steps that you already know.

  7. Dear “Santa”,

    If it’s so easy, why are so many people in debt up to their eyeballs? You sound inexperienced, so I’ll tell you: Because everyone knows what they are supposed to do, but very few actually do it. This is where Dave comes in. He’s an excellent motivator.

    The LDS Church’s advice is terrific, but generic. Dave Ramsey really takes it to the next level by giving you a very specific plan.

    By the way, I’ve never actually used Dave’s plan for getting out of debt, because I’ve never been in debt (except the mortgage, and that’ll be gone in at most 5 years, 3 months if everything goes according to plan).

  8. If you mean inexperienced in getting into debt, then I take that as a compliment. You are right I am not in debt either (excpet for the Mortgage. Even santa has to buy a home, go figure)

    I do disagree that the church’s program is generic. It provides simple yet specific instructions on mananging finances whether your are neck deep in debt or not. Now It doesn’t get into IRA’s, 401k’s, Stocks, Bonds etc. In that regard Mr. Ramsey would provide something of value.

    I didn’t mean to make this an attack on you personally either, though it kind of came across like that… It just is funny to me that people get more into debt by paying Mr. Ramsey to motivate them to get out of debt. It is just a sick never-ending circle. Ironically it is just like dieting :) I wonder how many other things fit this model… lol

    I find it interesting, in the housing market debacle, that borrowers who should never have qualified would have benefited in using their common sense. Unfortunately, we live in a society where no one seems to do their homework. Too many are a little too trusting. This only proves that nobody has our best interest in mind. We must work on our own due diligence to avoid harm from any party.

  9. I don’t think anyone has gotten into debt by paying Dave Ramsey. In fact, you cannot even purchase anything from his web site with a credit card. He is certainly not part of the “sick never-ending circle” you describe. You’re going to have to try harder than that if you want to discredit him.

    You ought to check him out — I think you’ll be pleasantly surprised. Why not check out his show in May? Or if you’re pinching pennies, I’d be happy to send you a copy of his book as my gift to you (we keep several on stock at all times).

  10. Dave,
    Dan would love how smart you are about the home loan. Good for you. The ideal thing is to pay more than you have to so you can get your loan down even quicker. Then it does b/come your money when the house is paid off! We are expats living in Russia and some people feel they need to own a home for a tax break when they live over seas. You can have a tax break…for a price!

  11. Well Dave, I have unfortunately gotten into one of these home equity loans which was a “BAD IDEA!” I was actually talked into it over the phone, it is now my only “mortgage loan”, the interest has sky rocketed, I have fallen behind in my payments and am now doing a “workout” with the company to get back on track! Then I don’t know how to get out of it because it has now affected my credit! I am only paying interest at this time and no principle! Any suggestions for help?????????????

  12. Thanks Dee!

    At our current rate, our home will be fully paid for in 5 years and 1 month from now (we’ve been in the house for 4 years and 3 months). Currently we are making double principle payments every month on our 15-year loan. It has taken pretty serious discipline to do it, but we are certain it will be worth it in the long run.

    A few years ago, back when the principle portion of our minimum payment was lower, we would make triple and even quadruple principle payments. That’s quite a bit harder now, since our minimum principle payment has naturally gone up significantly since then, but we still dump lots of money in every month.

    I’m just glad we bought our first house in a time when interest rates were in the single digits as opposed to your generation, paying 15% interest or more for their first home. I don’t think we could have made nearly the progress we have with triple the interest every month.

    –Dave

  13. Debbie,

    Having never been in your situation, I don’t feel qualified to give any advice, but I can at least encourage you to hang in there and get it paid off. If I were in your shoes, I would definitely call Dave Ramsey and ask him.

    –Dave

  14. Great information and I definitely agree – especially with the tax deductions. Thanks for sharing!

  15. I find it so hard to understand why anyone would have a hard time saving in this GREAT country. This by no means is an attack on people who are sufferring through bad debts, it is by all means my lack of insight. Here is how I see things.

    I immigrated to this wonderful country about 10 yrs back. I landed here when I was 23 with literally nothing but education. Got my first job and here is the plan I stuck to.

    – First thing: Took public transport to save enough money for 6-8 months to buy a car. Bought a nice car with most down and a 5 yr. loan on remainder

    – Second thing: Paid off the rest of the car loan in 6-8 months.

    – Third thing: Saved for a couple year and bought a house in the country where I come from.

    – Fourth thing: Saved for another 3 years and bought a house in a good neighbourhood (best public school, great community, close to all major highways and public transport) which will be enough for my family for next 5-6 years. Took a loan on remainder.

    – Fifth thing: Worked my rear off to pay off remainder of the home loan in 3 years.

    – Sixth thing: All the this time, I will save money for the next step and use it to purchase something. So, yes there were times when I had less than 1000.00 of total savings. SCARY!!

    – Seventh thing: Saved enough to last for 1 year. Kept this money aside and forgot about it. Will never touch it unless there is a real emergency.

    – Eight thing: All this time my first home (outside US) has tripled in value. With the rate at which it is anticipated to grow in next 10-15 yrs, that should take care of my kids college education.

    – Ninth thing: By this time my old car, which is about 10 yrs old now is no longer in the top shape. So, we are saving these days to buy a nice car that would last us another 10 yrs and will be big enough to accomodate our whole family.

    – Ten thing: Next thing after that will be move to a bigger house in the same neighbourhood and pay it off before I am 40.

    And lastly, I do not make more than an average person. And for all the skeptics and those who think we might have lived miserably, my first car was a BMW, I put my wife through a GREAT college and send my kids to a private school. And yes, all this time I maximized my 401k investment, which I have been growing with a decent rate of return every year.

    I by no means is the best financial planner, but here is what I will tell others. Always buy things that you enjoy and are durable (10 yr rule is a good one) and always do it one step at a time. And do not listen to anyone. Good luck!

  16. We have had a Home Equity LOC since 2005 and have never used it.
    Recently, we canceled the old and got another with a better rate-.51
    below prime.

    My wife works commission only and it is only there as an emergency
    measure so we don’t have to cash in some IRA money or sell some
    stocks if her market gets sour.

    Everything boils down to one thing–discipline. If you have it, LOC’s
    are great. If you don’t have it (and you know if you have it or not),
    stay away from LOC’s, credit cards, etc.

  17. Martin,

    Does that mean that if you have an emergency, you intend to go into debt to cover it? Is there any particular reason to not save up some cash for an emergency fund instead of leveraging your house?

    By the way, congrats for having the discipline to *not* use it. That’s more than most Americans can apparently do. Also, just for the sake of others reading this later, this article was not about Home Equity LOC’s (Lines of Credit). It was about Home Equity Loans, which obviously you must pay back starting immediately after getting the loan. This is different from an LOC which you only pay back *after* and *if* you spend any of it.

    –Dave

  18. I got a home equity loan some years after moving into a house. It was foreclosed last year(the house was).

    Do I still have to pay back the equity loan on the foreclosed house? Don’t seem like I have to being that they took what the equity loan was tied to.

    johnny

  19. Johnny,

    I have never personally experienced this but I’m told that the bank will sell the home to settle the debt. If the home doesn’t bring enough to pay off the loan balance, they will come after you for the difference.

    Bare in mind also that there could be two banks competing for the money: the first bank is the one who gave you the original mortgage, and the second bank is the one who gave you the home equity loan.

    Also, just to be clear: This was a home equity loan, and not a home equity line of credit, right?

    –Dave

  20. GREAT article, Dave. It’s fun to come back in late 2009 with the debris of the shattered housing market all around us and read this… You were ahead of your time.

  21. Another note on Helocs. I always thought they were great as an emergency fund until I wanted to refinance my existing mortgage and had to pay a $250 early termination on the Helco because it was less then 3 years old. I said I would restart it after the refinance. They said sorry, so I said sorry to I am not doing this again! Working on build an emergency fund instead.

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