Risks of home equity loans and how to avoid them
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Home equity loans can help homeowners take advantage of their home’s value to access cash easily and quickly. Borrowing against your home’s equity could be worth it if you’re confident you’ll be able to make payments on time, and especially if you use the loan for improvements that increase your home’s value. However, there are several risks involved if you fall behind on payments. Consider these risks, as well as the lender’s terms, before deciding to take out a home equity loan.
Risks of home equity loans
While all loans come with some level of risk, the fact that home equity loans are tied to your home means you should approach them with an additional layer of caution. Here’s what can happen:
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, HELOCs generally 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 mortgage lender Equity Now.
Because interest rate increases are unpredictable, HELOC borrowers could end up paying much more than they originally signed up for.
Home equity loans, on the other hand, typically have fixed interest rates for the life of the loan, so you’ll know exactly how much your monthly payment will be for the entire loan term.
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 a lower credit score — 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, as well as whether you could still afford them if your income were to change, and whether home equity loans are the best solution for your financial needs.
How value can rise and fall
After two years of home prices steadily climbing amid the pandemic and limited inventory of homes for sale, the real estate market has finally begun to moderate and cool.
The Federal Reserve raised the benchmark interest rate seven times in 2022 in an effort to tamp down inflation. The benchmark interest rate hikes in turn set the stage for increased rates on consumer borrowing, including for mortgage interest rates. The steeper cost of borrowing and resulting higher monthly mortgage payments dampened buyer enthusiasm. As a result, home price growth has been cooling recently and even fallen in some places.
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 might experience sticker shock once the draw period expires and the principal balance is added to your bill.
Your credit score can drop
Opening a home equity loan can also affect your credit score. Your credit score is made up of several factors, including how much of your available credit you’re using. Adding a large home equity loan to your credit report can negatively impact your credit score.
It is possible that having a home equity loan and making regular monthly payments on it can have a positive impact on your credit score as well.
When to avoid 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 home improvements or consolidate debt with a lower interest rate. However, a home equity loan is a bad idea if it will overburden your finances or 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, based in Temecula, California. 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,” says Sexton.
- To buy a car – It’s also not a wise idea to use home equity loans to purchase a new car. Sexton 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,” says Sexton. “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,” says Sexton. “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.
- To pay for college – Going to college can be a smart investment in your financial future, but using a home equity loan to pay for it is risky. There are other ways to pay for college that don’t require risking losing your home. If you’re thinking of college for yourself or someone in your family, consider one of those payment alternatives rather than taking out a home equity loan to pay for college. What’s more, rates on federal student loans are lower than those on HELOCs and home equity loans.
- To pay off credit card or other debt – It’s true that a home equity loan has lower interest rates than credit cards and most other forms of debt, but that doesn’t mean it’s a good idea to use one to pay off credit card or other debt. This is especially the case if you borrow the maximum you can on the home equity loan, which would put you at risk of becoming upside-down on your mortgage. If you haven’t addressed the factors that caused you to get into high-interest debt, you’re likely to find yourself in a worse position. You might find you still don’t pay off your credit card each month, and you’ll also have a home equity loan payment on top of it.
- To invest in real estate – Real estate investments are fairly speculative and can go up or down. Even if your real estate investment goes well, it can be hard to get your money back out in order to repay your home equity loan.
Alternatives to a home equity loan
When you need to access cash and a home equity loan is not a viable option, there are alternatives. The options include:
- Personal loan: A personal loan can be easier to obtain and the funds often are available in just days. Though you may not be able to access as much cash using a personal loan as you would with a home equity loan.
- Credit cards: Depending on how much money you need, using a credit card may be an option. However, many credit cards have steep interest rates these days. So if you’re considering using a credit card try shopping around for a card that offers a 0 percent introductory rate. And then be sure to pay the balance off in full before the introductory period ends.
- Cash-out refinance: A cash-out refinance is an entirely new mortgage that you take out on your home for more than the amount you owe on the property. The extra money you are borrowing would be provided in a lump sum of cash.
Some mortgage 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 aren’t worth taking; in some cases, a home equity loan can be a good idea, especially if you use the funds to renovate your home.
“In 2020, 2021 and the first half of 2022, many clients took out home equity loans to remodel and sell their property to create a larger profit,” Sexton says. “However, interest rates in 2023 have increased significantly, and the real estate market has declining in value. Taking out a home equity line to remodel and sell your home is a risky proposition.”
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.