Risks of home equity loans and how to avoid them

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Home equity loans allow homeowners to borrow against the equity in their homes, giving them easy access to cash. However, although equity borrowing can be practical and convenient, there are risks if you fail to make loan payments. Risks of home equity loans include extra fees, a lowered credit score and even the chance of foreclosure. It’s best to keep these in mind when considering whether this type of loan is a good idea for your financial situation.

The main risks of a home equity loan are:

When you should not take out a home equity loan

Because home equity loans use your home as collateral to secure the loan, it’s important to weigh the pros and cons of this type of borrowing carefully. A home equity loan could be a good idea if you use the funds to make improvements on your home or consolidate debt with a lower interest rate. However, a home equity loan is a bad idea if it will overburden your finances or if it only serves to shift debt around.

If you’re thinking of taking out a home equity loan, it’s best to avoid using it in the following scenarios.

To help solve monthly cash flow problems

It’s generally not a good idea to resort to a home equity loan if you’re using the money simply to help resolve day-to-day money shortfalls in your household or living budget, says Steve Sexton, financial consultant and CEO of Sexton Advisory Group. After all, a home equity loan still needs to be repaid, and failure to keep up with payments could send you deeper into debt.

“If you’re hoping it will help your cash flow problems, it will likely do the opposite if you don’t have a structured plan to pay back the loan,” Sexton says.

To buy a car

It’s also not a wise idea to use home equity loans to purchase a new car, adds Sexton, who describes this as simply moving debt from one place to another without actually solving the root financial issues, which are typically poor spending habits or overspending.

“A car is a depreciating asset,” Sexton says. “There is no long-term value. And if you lose your job and cannot make the payment, you’re looking at a home foreclosure.”

To pay for a vacation

“Using home equity loans to fund leisure and entertainment indicates you’re spending beyond your means,” Sexton adds. “Using debt to fund your lifestyle only exacerbates your debt problem.”

If taking out a loan to pay for a vacation would stretch your monthly budget — and put your home at risk — it’s better to hold off on the loan and start a vacation-specific savings fund instead.

What are the risks of a home equity loan?

While all loans come with some level of risk, the fact that home equity loans are tied to your home means that you should approach them with an additional layer of caution.

Interest rates can rise with some loans

There are two main types of loans that use your home equity as collateral: home equity loans and home equity lines of credit (HELOCs). While loan terms vary by lender and product, generally HELOCs have adjustable rates, which means that payments increase as interest rates rise.

“The interest rate on a home equity line of credit is often tied to the prime rate, which will move up if there’s inflation or if the fed raises rates to cool down an overheating economy,” says Matt Hackett, operations manager at Equity Now. “It’s impossible to know when this will happen, which is why this can be risky.”

Because interest rate increases are unpredictable, HELOC borrowers could end up paying much more than they originally signed up for.

Solution: Convert your HELOC balance into a fixed rate during your draw period or look for a fixed-rate home equity loan. Some lenders offer fixed-rate HELOCs and HELOC conversions. This gives you a chance to pay off or pay down your balance while the rate is locked.

Your home is on the line

The stakes are higher when you use your home as collateral for a loan. Unlike defaulting on a credit card — where the penalties are late fees and lowered credit — defaulting on a home equity loan or HELOC means that you could lose your home.

Before you take out a home equity loan, do your homework. Ask yourself if you have sufficient income to make regular payments and whether home equity loans are the best solution for your financial needs.

Solution: Talk with a financial adviser about whether a home equity loan can help you achieve your objectives. An adviser can help you look at the numbers and make an informed decision based on your current and projected financial situation.

Equity can rise and fall

As home prices continue to climb, it’s hard to imagine your home losing value. But that’s exactly what happened a decade ago during the housing crisis.

Property values plunged, which had a massive impact on some homeowners who borrowed against their equity via home equity loans and HELOCs. Many people became upside-down on their mortgages, which happens when you owe more than the fair market value of your house.

Solution: Don’t borrow more than you need, and try to use your loan funds to make improvements to the home that could increase its value.

Paying the minimum could make payments unmanageable down the line

Many HELOCs require interest-only payments for the first 10 years, or the draw period, which is when you’re allowed to access the credit. If you only make these minimum payments, you won’t make any progress in paying the principal.

After the draw expires, borrowers enter a repayment period where they have to pay both principal and interest and can no longer draw on the credit line. If you borrowed a large amount during the draw period and only made minimum payments, you may experience sticker shock once the draw period expires and the principal balance is added to your bill.

Solution: Keep track of how much you’re borrowing and make sure you have a plan to repay it — factoring in both interest and principal payments.

The bottom line for people considering home equity loans

Some lenders position equity as money that’s just sitting around, waiting to be used. But the reality is that home equity loans are just that: loans. It is money that must be paid back and it comes with fees and interest, which can ultimately end up costing you thousands of dollars on top of your initial loan amount.

That’s not to say that the risks of a home equity loan are not worth taking; in some cases, a home equity loan can be a good idea, especially if you use the funds to renovate your home. “For example, one of my clients took out a home equity loan to remodel and expand their home with plans to sell the home shortly after the renovation,” says Sexton. “Three months after the renovation, the home was sold creating an additional $100,000 profit after all of the loans were paid off.”

Before committing to a home equity loan, consider your financial situation and compare home equity rates, terms and fees from a variety of lenders to see how much it could cost you.

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