Risks of home equity loans and how to avoid them

Home equity loans can help homeowners take advantage of their home’s value to access cash easily and quickly. Borrowing against your ownership stake 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 financing is tied to your home — and use it to back the debt — means you should approach them with an additional layer of caution.

There are two main types of loans that use your home equity as collateral: home equity loans and home equity lines of credit (HELOCs). Here’s what can happen with both or one of them.

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.

Home values can change

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 steeper cost of borrowing and resulting higher monthly mortgage payments have dampened buyer enthusiasm. As a result, home price growth has stagnated, and even fallen in some places.

If your home value falls, you could wind up owing more in mortgage and home equity debt than your house is worth — a situation known as negative equity. If you’re underwater or upside-down like this, it can be a real problem, especially if you try to sell your home.

Bankrate insight:

Interest rates can rise with some loans

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 rates are unpredictable, HELOC borrowers could end up paying much more than they originally signed up for — especially if rates rise quickly, as they did in 2022. In the worst cases, your monthly payments could become unaffordable.

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.

Paying the minimum could make payments unmanageable down the line

While you can usually pay back whatever you borrow at any time, many HELOCs require interest-only payments for the first 10 years, or whatever the length of their draw period (when you’re allowed to access the funds). Tempting as that is, if you only make these minimum payments, you won’t make any progress in paying down your outstanding balance.

After the draw period expires, borrowers enter the HELOC’s repayment period: They start repaying both principal and interest and can no longer use 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 principal balance is added to your monthly 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. That could make it harder to qualify for other loans in the immediate future. For example, if you get a home equity loan right before you buy a car, it could mean getting a worse deal on your auto loan.

In the long run, it is possible that having a home equity loan and making regular monthly payments on it can help your credit. Just be aware of the short-term drop you’ll likely see.

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 holiday 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 invest in real estate

Investing is always a laudable goal, but going into debt to invest is debatable, especially if you’re not a day trader or venture fund capitalist. Real estate investments in particular are fairly speculative and, more importantly, highly illiquid. Even if your real estate investment goes well, it can take years to see appreciation, and it will be hard to get your money back out in order to repay your home equity loan.

To pay for college

This one is not so much a total avoid as a consider-it-carefully. True, going to college can be considered an investment in terms of skills and careers. And using home equity loans can be a smart strategy — especially HELOCs, which are tailor-made for expenses incurred in installments over a long time period. You can just withdraw what you need for that year’s or that semester’s tuition, and only incur interest on that particular amount. You or your child also can start paying it back, rather than be hit with a mountain of debt after graduation.

But there are other ways to pay for college that don’t require risking losing your home. What’s more, interest rates on federal student loans are lower than those on HELOCs and home equity loans.

To pay off credit card or other debt

This is another case of think-hard-about-it rather than forget-about-it.

It’s true that a home equity loan has lower interest rates than credit cards — much lower — and personal loans, because it’s secured. Swapping expensive debt for cheaper debt is not the worst idea in the world. In fact, it’s a fundamental reason people do debt consolidation in the first place.

But be careful. 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 yourself running up a new set of outstanding credit card balances, and you’ll now also have a home equity loan payment on top of them.

How to protect yourself from the risks of home equity loans and HELOCs

If you do take the home equity loan plunge, go about it in a smart way.

Don’t borrow more than you need

Given that you’re putting your home at risk, it’s key to make sure you only borrow exactly as much as you need and that repayments are affordable.

Before you apply, it’s a good idea to talk with a financial advisor about whether a home equity loan can help you achieve your objectives. An advisor can help you look at the numbers and make an informed decision based on your current and projected financial situation.

Create and stick to a budget

When you get your home equity loan or HELOC, it’s easy to feel like you have a huge pool of cash. That makes it easier to spend superfluously.

When you get your loan, create a budget and stick to it. Make sure that the budget includes your new loan payment so you can make good progress on paying down the balance. If you opted for a HELOC, make sure that budget includes payments for both interest and some of the principal.

Even if principal payments aren’t required immediately, paying down principal during the draw period can save you a lot of money (in smaller interest charges) and avoid a nasty payment spike when the draw period ends.

Refinance your HELOC into a fixed-rate HELOC

If you sign up for a HELOC with an adjustable rate, you can always consider  converting your HELOC into a fixed rate during your draw period or after it ends (assuming the lender allows it — another thing to look for when comparing offers). Many 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.

Or you could look into refinancing the HELOC into a fixed-rate home equity loan. That will protect you from unexpected shifts in interest rates, which can increase your monthly payments. Just be sure to read the fine print of your loan to make sure there isn’t a prepayment penalty.

Monitor your credit score

Keep an eye on your credit score and how your home equity loan impacts it. In all likelihood, adding a new, large debt to your report will drop your score in the short term.

Keep an eye on your score and see how it changes as you make payments or draw additional funds from your HELOC. If it drops significantly, you might want to consider not drawing more funds from your HELOC or stepping up your efforts to pay off the loan.

Use it for the right things

Using your home equity loan for the right purposes is key. For example, getting a home equity loan to take a luxury vacation you couldn’t otherwise afford isn’t a great idea. Using it to consolidate high interest debt into a lower-cost loan may be a better call.

Even better would be to use the funds to make improvements to your home. Putting a home equity loan towards substantial renovations or repairs, or even a new home down payment, may let you deduct the interest at tax time. And the remodels can also boost the value of your home.

Consider consulting a financial advisor before you apply for a loan to make sure that the loan will help your financial situation rather than harm it.

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. However, 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.

Bottom line on home equity loan risks

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 a debt 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 upgrade, update or otherwise improve 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. Since interest rates have risen and the real estate market slowed, those quick turnaround days are largely gone. But using home equity as a long-term investment in your home, enhancing its worth, can still be a sound strategy.

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.