If you need money and have paid off a decent chunk of your mortgage, a home equity loan can be a tempting option. These loans generally carry lower interest rates than other consumer loans, because they are secured by real estate.
Using your home as collateral isn’t an issue if the borrowing terms are reasonable and your finances are in order. Nevertheless, it can quickly turn into a nightmare under the wrong circ*mstances. Fail to keep up with repayments, and you risk losing your property and maybe even getting sued.
Key Takeaways
- If you’re unable to repay a home equity loan, the lender generally will only foreclose on the property that you used as collateral if a sale will raise enough to recoup what is owed.
- The home equity loan lender can only collect from a foreclosure once the first mortgage has been paid off.
- In other words, the home must be worth more than what is owed on the first mortgage to make foreclosure worthwhile to the second mortgage holder.
- If foreclosure isn’t a pursuable option or doesn’t pay off enough of the debt, the lender will likely try to sue.
- Uncollectable debt is treated as ordinary income by the Internal Revenue Service (IRS).
What Are Home Equity Loans?
A home equity loan basically enables you to use your home equity as collateral to borrow a lump sum of cash. For example, if your property is valued at $500,000 and you owe $200,000 on your first mortgage, you have $300,000 in equity that can be used as a guarantee for a second loan.
Lenders will offer more competitive borrowing rates if you use your house as collateral, because it gives them something valuable to seize and sell to recoup some or all of their losses if you are unable to keep up with payments. This means cheaper loans but also the risk of losing your house if you default.
What Happens If I Don’t Pay My Second Mortgage?
If, for whatever reason, you are unable to repay a home equity loan, the lender may choose to foreclose on the house that you used as collateral. The creditor’s actions usually depend on the value of your home, whether there are any other liens against it, and how much money you still owe.
When a borrower defaults on their first mortgage, the loan used to buy the home, lenders are highly likely to begin foreclosure proceedings to get their money back. Whether this same approach is adopted on a second mortgage depends on the property’s value and how much equity the borrower has in it.
This is because the first mortgage lien, by virtue of being recorded in county land records earlier, is given higher priority. Thus, if you fail to repay your home equity loan and the secured house is sold to satisfy the debt, the proceeds will be used first to extinguish whatever is left to pay on the initial mortgage. The second mortgage lender can only begin to collect what it is owed once the more senior lien has been honored and paid off.
The more home equity you have, the more likely your lender will choose to foreclose.
Homes with Higher Values
If your home is currently worth more than what you owe on your first mortgage, selling it should enable the home equity loan provider to recover the money that it lent to you, or at least a reasonable portion of it. In that case, the lender will likely initiate a foreclosure.
Think about it like this: The more money that the second mortgage holder can potentially recoup from a foreclosure sale, the more likely it will take this path.
Most home equity loans are recourse loans, meaning that in the event of a default, the creditor has full autonomy to pursue the borrower for the total debt owed, even beyond liquidating the collateral.
Being Underwater
If you’re underwater, meaning that your home is worth less than the amount you owe on your first mortgage, your second mortgage is effectively unsecured. In that scenario, the second mortgage holder probably wouldn’t see a cent from pushing through a sale, making foreclosure a waste of time and resources. Other methods, if enforceable, would be necessary to recoup what it is owed.
Should the home equity loan lender find itself in this position, it may—if state law allows it and it is worth its while—sue you in court to collect on the debt. With a deficiency judgment, the lender can seize bank accounts, garnish wages, and place liens on other properties to retrieve the outstanding balance—making your life a misery and destroying your credit rating in the process.
And the chasing doesn’t stop there. If, after exhausting all debt-collecting methods, the lender is still out of pocket, it can report the debt deemed uncollectable to the Internal Revenue Service (IRS). The IRS treats canceled debt as ordinary income. Thus, if you have $5,000 of canceled debt and are in the 22% tax bracket, you’ll be taxed $1,100.
If what you owe in taxes is unaffordable, it’s possible to set up a payment plan. However, the IRS will charge you for this privilege.
Special Considerations
When you struggle to make repayments, mortgage lenders can seem like the enemy and best to avoid at all costs. Do not fall into this trap. Open communication from the start can prevent a slight mess from turning into a financial disaster.
Don’t bury your head in the sand and hide. It’s in the lender’s best interest to recoup the money as effortlessly and cheaply as possible, and foreclosures and lawsuits are generally effortful and expensive. Your lender may be open to finding an alternative solution and giving you more time if you prove yourself to be communicative and trustworthy.
What happens if a lender gives you more credit than you are able to repay?
It should never get to this point. First, borrowers should read any paperwork before signing and never agree to something that they don’t understand or cannot afford. Second, lenders are heavily regulated and, in theory, aren’t permitted to dole out loans that their clients are unable to repay. If your debt is beyond your means, you could lodge a complaint of irresponsible lending.
Can you pay a home equity loan off early?
Absolutely. However, before proceeding, you’ll want to determine if the loan carries prepayment penalties and, if so, whether they make paying the debt ahead of schedule a wise move.
Does a home equity loan affect your credit score?
According to a study by LendingTree, most borrowers initially see a decline in their credit score after taking out a home equity loan. However, this decline is small and tends to recover within a year—provided, of course, that the borrower keeps up with loan payments.
The Bottom Line
Defaulting on a home equity loan can result in foreclosure if it makes sense financially for the lender. The more home equity you have, the more likely the creditor will pursue this course of action.
It doesn’t stop there, though. Lenders of recourse loans can try every available route to claw back what they’re owed. If foreclosure isn’t sufficient, then your wages, savings, and other assets could be targeted and stripped away.
This should serve as a reminder of how dangerous home equity loans can be. Don’t sign up for one unless you fully understand the terms and are certain that you can keep up with the repayments.
