Home equity loans: What are the risks? How to avoid them
Home equity loans are a way for homeowners to quickly access cash and take advantage their home’s wealth. Borrowing against the equity in your home could be a good idea if you have the ability to make timely payments and especially if you plan on using the loan to improve your home’s worth. There are risks if you fall behind in payments. These risks should be considered along with the terms of the lender before you take out a home-equity loan.
There are risks associated with home equity loans
Although all loans carry some risk, home equity loans can be a good option. However, they are linked to your home so you need extra caution. Here’s what could happen:
With some loans, interest rates may rise
Home equity loans and home Equity lines of credit (HELOCs), are the two types of loans that can use your home equity as collateral. While loan terms will vary from product to product, HELOCs typically have adjustable rates. This means that the payments can increase as interest rate rises.
“The interest rate on your home equity line of credit is often tied with the prime rate,” Matt Hackett (operations manager at Equity Now), says.
HELOC borrowers might end up paying more than they initially signed up for because interest rate rises are unpredictable.
For home equity loans, however, you can expect fixed interest rates over the term of the loan. You will be able to know the exact amount of your monthly payment for the entire loan term.
Solution: Convert your HELOC to a fixed rate within your draw period. Or, look for a fixed interest home equity loan. Some lenders offer HELOCs with fixed rates and HELOC conversions. This offers you the opportunity to pay off or lower your balance, while the rate is locked.
Your home is up for grabs
When you use your home to secure a loan, the stakes can be higher. A default on a home equity loan (or HELOC) could result in your losing your home, unlike defaulting on credit cards where there are penalties such as late fees and lower credit scores.
Do your research before taking out a home equity mortgage. Consider whether your income is sufficient to cover the regular monthly payments. Also, consider whether your income could change to allow you to decide if home equity loans are the right solution for your financial situation.
Solution Speak with a financial professional to determine if a home equity loan is right for you. An advisor can help with the calculations and make informed decisions based upon your financial situation.
How value can fluctuate between rising and falling
Two years of rising home prices in the face of a pandemic, and a limited number of homes on the market, has seen the real estate market finally slow down and cool.
To reduce inflation, in order to keep it down, the Federal Reserve raised its benchmark interest rate seven-fold in 2022. These benchmark interest rate rises set the stage for higher rates for consumer borrowing, as well as mortgage interest rates. Buyer enthusiasm was dampened due to the increased cost of borrowing, and consequently higher monthly mortgage payments. This has led to a cooling in home price growth, some even dropping in certain areas.
Solution You shouldn’t borrow more money than you actually need. Even better? Use your loan funds for home improvements that could increase the property’s value.
Payments could become difficult if you pay the minimum.
HELOCs typically require interest-only payments during the first 10 year or draw period. That is when you are allowed to access the credit. These minimum payments will not make you any progress towards paying the principal.
After the draw period expires, borrowers are required to repay both principal and any interest. Sticker shock can occur if you borrow a lot during the draw period, but you only make minimum payments.
Solution Keep a record of the amount you borrowed and create a plan for repaying it. This will include principal and interest payments.
Credit score can plummet
A home equity loan may also have an impact on your credit score. Your credit score is dependent on many factors. This includes how much of your credit you use. Your credit score can be negatively affected by adding a large home equity mortgage to your credit report.
A home equity loan can be beneficial for your credit score. You should also make regular monthly payments.
Solution: Check your credit score regularly. This will allow you to monitor any impact your home equity loans has on your credit score.
What to do if you don’t want a loan for your home equity
Home equity loans can be secured with your home, so it is important to consider the pros and cons. Home equity loans can be beneficial if you intend to consolidate or make improvements to your home. If you have a lot of debt or if your finances are already tight, a home equity mortgage is not a good idea.
If you are thinking about taking out a loan to your home equity, it is best to not use it in the following situations:
- To resolve monthly cash flow problems – It is generally not a good idea for a homeowner to take out a loan to fund your daily living expenses. You must repay the home equity loan. If you don’t pay your payments on time, it could make it harder to repay. Sexton states, “If it’s hoped it’ll help your cashflow problems, it’ll likely do the contrary if there’s no structured plan to repay the loan.”
- To buy car – Home equity loans are not wise to use to purchase a vehicle. Sexton describes it as simply shifting debt from one place or another without solving the root financial problem, which is usually poor spending habits or excessive spending. Sexton states that a car is an asset that will eventually lose value. “There is no long term value. If you lose your employment and can’t make the payments, you could be facing a home foreclosure.”
- To finance a vacation – “Using your home equity to fund entertainment and leisure means you’re overspending,” Sexton states. “Using debt as a way to fund your lifestyle is a recipe for disaster,” says Sexton.
- To fund college – Although going to college can be a wise investment in your financial future it can also make you a risky borrower from your home equity. There are many other ways to pay college costs that won’t involve losing your home. You might consider these payment options when you think about paying for college for someone you love or for your family. The rates for federal student loans are also lower than home equity loans and HELOCs.
- To pay down credit card or any other debt – Although a home equity loans has lower interest rates than most credit cards and other types of debt, it is not advisable to use one to repay credit card or any other debt. This is especially true if the home equity loan exceeds your limit. If you do, you could be liable for being upside-down on the mortgage. You will likely be in a worse financial position if you haven’t dealt with the reasons that led you to high-interest debt. You may find that your credit card debt is still not paid off each month. Additionally, you will have to pay a home equity loan monthly.
- To make a real estate investment – Investments in real estate are quite speculative. They can be up or down. Even if your realty investment is successful, it may be difficult to get your loan repayments back.
Alternatives to a loan for home equity
Alternatives exist if you don’t have the cash available for a home equity mortgage. These are the options.
- Personal Loan: It is easier to get a personal loan and often the funds can be available in a matter of days. A personal loan may not allow you to access the same amount of cash as a home equity loan.
- Credit Cards: The amount of money you need to make a purchase may determine if a credit line is an option. Unfortunately, credit cards can have very high interest rates. Consider shopping for a credit-card that offers a zero percent introductory rate if you’re thinking of applying. Then, make sure you have paid the full amount before the introductory period ends.
- Cash out refinance: This is an entirely new type of mortgage you can take out on your house for more than you owe. The additional money that you borrow would be paid in cash lump sums.