Home equity loans – why they are largely misunderstood

Given the uncertainty of interest rates and remnant challenges rooted in the coronavirus pandemic, an increasing number of borrowers are turning to home equity loans for much-needed funds and financial relief. Yet according to a new study, about half of those availing themselves of the financing have a strong understanding of how a home equity loan works.

The survey by MeridianLink – a provider of modern software platforms for financial institutions and consumer reporting agencies – found that while 21% of respondents are likely to take out a home equity loan in the next 12 months, only 52% have a strong understanding of how a home equity loan works.

“Elevated interest in home equity lending is driven by the current economic environment with high house prices and interest rates slowing purchase transactions and providing existing homeowners with high available equity,” MeridianLink's president, Go to Market Chris Maloof told Mortgage Professional America. “Not all loans are the same and it’s important for financial institutions to offer a range of options for consumers and help educate them on the type of loan most appropriate for their situation. Financial institutions that help consumers with lending options can create more opportunities for themselves and their members or customers.”

Read more: Tapping home equity has become all the rage

Home equity loans are taken to fulfill a wide variety of needs, Maloof explained: “While I can’t speak for people’s unique lending needs, some traditional reasons people take out home equity loans are to fund home renovations or cover the cost of major life events. How a borrower uses the funds from a home equity loan can have tax implications, and it is important that a lender is able to provide appropriate guidance. “

Despite their growing popularity, a great number of people don’t fully grasp the intricacies of home equity loans. Among the survey findings:   

• 48% of respondents scored their understanding of a home equity loan below a 7 out of 10. 
• 13% had no understanding at all (scoring a 1/10). 18% reported having a complete understanding (scoring a 10)  
• The average response was a 6.3 out of 10 
• Although those under the age of 55 are more likely to take out a home equity loan in the next 12 months, they are less knowledgeable about how home equity loans work (30% scored a 1/10) compared to those over the age of 55 (only 9% scored a 1/10). 

• Those in the Northeast are more likely to take out a home equity loan this year (31%) compared to Midwest (22%), South (18%) and West (19%)  
• Those living in urban areas say they are more likely to take out a home equity loan (36%) in the next 12 months compared to those living in rural or suburban areas.

Tim Wheeler, vice president, corporate lending at Fortera Credit Union, expounded on the widespread lack of understanding as it relates to home equity. “Home equity loans and lines of credit typically have terms, disclosures, and fees not associated with other forms of consumer credit,” he told MPA. “While closed end home equity loans share characteristics with first mortgage products, which are more familiar to consumers, they’re not as common as other forms of credit. Home equity lines of credit can have varying payment types” he said, citing fixed payments or interest only as examples, “draw periods, and maturity. Borrowers should take extra care to ensure they understand the specific terms before proceeding.”

Consumers should also be aware of potential pitfalls: “Using equity may cause additional risk if the borrower decides to sell the property in the future,” he said. “Depending on the combined loan to value position, they may not realize the net gain/profit they were expecting. An additional risk would be using equity built over time to pay routine, recurring expenses as opposed to, say, paying off higher interest debt or making a single major purchase (such as a home improvement or repair). Equity lines and loans should be carefully managed as part of the overall budget of the borrower. Lenders should offer educational tools and programs to assist borrowers who encounter financial hardship.”

Read next: Home equity lenders – what their growth hinges on

While soaring property values have given rise to increased tapping of equity, consumer are urged to be conscientious while turning to such loans: “Borrowers should only use the amount needed,” Wheeler said. “With growing property values, some borrowers feel the need to secure a larger loan to increase available credit. This could risk future profit/gain in the event property values stabilize or decline. In most cases, a maximum loan to value of 80% benefits both the borrower and lender.”

Educating oneself on equity loans is paramount given the lack of institutionalized primers available to consumers, Wheeler noted. “Unlike first mortgage applications, most equity loan products do not require any consumer educational materials be provided prior to approval,” he said. “Many financial institutions do, however, offer educational content related to home equity loans and lines of credit. As an additional reference, many third-party websites offer content related to understanding equity products.”

He offered a final bit of guidance to those mulling the idea of tapping into their home equity: “My biggest piece of advice is to carefully review their early disclosure documents,” Wheeler said. “If any information is unclear, schedule an appointment with your lender. Lenders should engage with prospective borrowers to ensure understanding and long-term success.”

Having built robust equity in one’s property is one of the advantages to homeownership. But with the introspection often attendant to the holidays, it may be prudent to not rest too heavily on such laurels.