Home equity loans allow homeowners to borrow against the equity in their homes, giving them easy access to cash. Although equity borrowing can be a practical and convenient option, it also comes with risks.
Because lenders use your home as the collateral in home equityfiloans, failure to make payments not only leads to late fees and hits on your credit report, but it can also mean foreclosure.
Here we look at some of the major risks of home equity loans and help you decide whether a home equity loan is a good idea for your financial goals.
Interest rates can rise, prompting your payments to surge
There are different types of loans that use your home equity as collateral, including home equity loans (HELs) and home equity lines of credit (HELOCs). Loan terms vary by lender and product but, typically, HELOCs have adjustable rates, which means your payments will increase as interest rates rise.
Since there’s no way to know when interest rates will rise, HELOC borrowers could end up paying more than they initially expected. Rising interest rates make your monthly bills more expensive because the total interest you pay on the loan is greater. The reverse is true when interest rates fall.
Solution: Convert your HELOC balance into a fixed rate during your draw period. Some lenders offer fixed-rate HELOCs and HELOC conversions. Chase, for example, offers a fixed-rate lock option that allows eligible borrowers to switch from a floating or variable rate to one that doesn’t change during a specified period of time. This will give you a chance to pay off or pay down your balance while the rate is locked.
Equity borrowing means your home is on the line
The stakes are higher when you use your home as collateral for a loan. Unlike defaulting on credit card payments — where the penalties are late fees and smeared credit, defaulting on a HEL or HELOC means that and more: you could end up losing your home.
It’s important to do your homework before you take out a home equity loan. Ask yourself if you’re disciplined enough and have sufficient free cash flow to pay it back and whether home equity loans are the best solution for your financial needs.
Homeowners shouldn’t approach HELs and HELOCs as a spigot of free cash locked up in a house, cautions Greg McBride, CFA, Bankrate’s chief financial analyst.
“Borrowing against your home equity is not the same as going to an ATM and withdrawing cash–this is a loan and you will pay interest and fees,” McBride says.
Solution: Talk with your 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 a decision based on your current and projected financial situation. Make sure you understand the terms and features of the loan before you sign on the dotted line.
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 HELs and HELOCs. This caused many people to become upside down on their mortgages, which happens when you owe more than the fair market value of your house.
For instance, if your house is worth $320,000 today and your mortgage balance is $300,000 and the home’s value drops to $250,000, you still owe $300,000. A situation like this can make it difficult or impossible to sell your house.
Solution: Don’t borrow more than you need and don’t borrow if you know you won’t be in the home long enough to ride out a possible decline in home values. Also, try to pay off the loan as soon as possible to recoup the equity in your home and hedge against a downturn.
Paying the minimum on a HELOC means treading water
After 10 years, a HELOC really loses its benefit, warns , says Michele D. Hammond, a private client home lending adviser with Chase. Folks who only plan on making minimum monthly payments risk never paying off the loan.
“It’s beneficial to pay off the balance before the end of the 10 years. After that, it’s a 20-year repay and the payment shoots up,” Hammond says.
Borrowers should keep in mind that many HELOCs only require interest-only payments for the first 10 years, or the draw period, which is when you’re allowed to access the credit.
After the draw expires, borrowers have to pay both principal and interest and can no longer draw on the credit line. If you borrow a large amount and only make 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 a plan to repay the amount within 10 years — that means making both interest and principal payments. Also, keep in mind, that the interest rate can rise, so by paying off the balance sooner you reduce your risk of rate-hike exposure.
The worst thing you can do, McBride says, is to use a HELOC as a way to subsidize a lifestyle you can’t afford.
The bottom line for people considering home equity loans
Some lenders will position equity as money that’s just sitting around, waiting to be used. When in fact, home equity loans are loans. They come with fees and interest and can end up costing borrowers thousands of dollars in interest, none of which will be tax deductible unless the money is used to buy or renovate your home.
It’s important to shop around to get favorable terms and rates. Be sure you’re clear about the features of your home equity loan.
Finally, it’s always prudent to speak with a financial adviser when in doubt.