For many homeowners, borrowing against the equity in your home is an attractive option now, thanks to surging home values over the past two years. But before you take out a home equity loan or a home equity line of credit, you need to be certain you understand the risks associated with home equity loans.
Read on to learn what the specific financial risks are when it comes to HELOCs and home equity loans and how you can avoid them.
How does a home equity loan work?
Home equity loans let you borrow money against the equity you've built up in your home and provide you with a lump sum of cash at a fixed interest rate. HELOCs are also equity loans, but they function like a revolving line of credit, which means you can take your money out in multiple installments, and your interest rate is variable, so your monthly payments will change.
Equity loans are useful and can be cost-effective ways to access cash at lower interest rates compared to other types of loans, such as personal loans or credit cards. For example, home equity and HELOC rates are both under 7% right now, while personal loans have an average interest rate of 10.7%, according to Bankrate, CNET's sister site. But they come with major risks, such as home foreclosure, that other types of financing don't involve. Most homeowners use home equity loans for major life expenses such as home renovations and to consolidate other kinds of debt. As long as you have built up at least 15% to 20% equity in your home, lenders will typically allow you to borrow up to 85% of your home equity.
What are the risks of home equity loans?
You can lose your home.
The biggest downside to any type of home equity loan is that you must use your house to secure the loan. When using your home as collateral to secure a loan, the bank or lender can take possession of your house to repay themselves if you miss payments or default on your equity loan for any reason.
"You put up your home as collateral for both a home equity loan and a HELOC, which means that if you fail to make payments on either, you could lose your home through foreclosure," says Robert Heck, VP of mortgage at Morty, an online mortgage marketplace.
For most people, losing their house is a much more significant consequence than a lower credit score, which is why it's vital to carefully consider whether you can manage paying back a home equity loan over an extended period of time.
Variable interest rates may break your budget.
With HELOCs, one downside to consider is that they have variable interest rates, which means you won't have consistent monthly payments. What you are required to pay each month will increase or decrease with interest rate trends overall. HELOC rates are impacted by the prime rate, which is currently at 5.5%. The prime rate is the interest rate banks use to determine lending rates, as well as economic policy set by the Federal Reserve. So far this year, the Fed has raised interest rates four times and plans to continue raising them.
That means it's likely your HELOC payments will increase in the near future in our current economic environment. So it's critical to make sure your income can comfortably accommodate the fluctuations in your monthly payments.
Home equity loans, on the other hand, have fixed interest rates. In a rising interest rate environment, like the one we're experiencing today, that can prove beneficial for homeowners who won't have to worry about their rates -- and therefore their payments -- increasing.
You will make higher monthly payments if your rate goes up.
If interest rates remain high, or rise, be prepared to continue making higher monthly payments over time with a HELOC. With experts predicting a potential recession on the horizon, it's important to consider how secure your employment is, and how much of an emergency savings cushion you have should any major life events occur such as a job layoff. Most financial experts recommend keeping at least three to six months of living expenses in an emergency fund if possible.
Make sure you can afford to keep making payments on both your first mortgage as well as your equity loan (more commonly referred to as a second mortgage), should any changes happen to your financial circumstances.
With a home equity loan, however, you never have to worry about your monthly payments increasing because such loans have a fixed interest rate that doesn't change. Currently, the average interest rate for a $30,000 home equity loan is hovering around 7% and HELOCs are at 6.5%, according to Bankrate.
An increase in debt can lower your credit score.
A HELOC is a revolving line of credit that functions like a credit card, so maintaining a high balance over time can lower your credit score. While one benefit of a HELOC is that you can make interest-only payments during the initial draw period, once your repayment period begins, your monthly payments will jump because you'll also begin paying back the principal.
Make sure you can manage such an increase comfortably within your budget. Use Bankrate's HELOC calculator or home equity loan calculator to determine whether your monthly budget can handle a second mortgage payment. Making consistent and on-time payments for your HELOC can impact your credit score positively, as well.
Falling home values can limit your loan.
After two years of record home value appreciation, home prices across the US are, on average, up 42% since the beginning of the pandemic.That's good, until a recession or other cataclysmic economic event causes home values to drop again, in which case, borrowing against the equity in your home could backfire.
When your outstanding loan balance ends up being higher than the value of your home, your lender has the option to freeze or reduce your line of credit since your home can no longer serve to secure the loan. Having a larger loan balance than what your house is worth is known as negative equity, or when you are "upside down" on your mortgage.
How to protect yourself from the risks of home equity loans
If interest rates continue to rise, which experts expect, one option is converting a HELOC into a fixed-rate HELOC or home equity loan so you can fix your interest rate and keep your payments consistent.
In general, it's prudent to consult with a financial advisor when making significant financial decisions such as taking out a loan against your home. Financial professionals can help you figure out whether such a loan makes sense for your long-term financial goals.
No matter what, it's crucial to model out different versions of your budget to make sure you can afford your monthly payments even if your financial circumstances change. Determine what the maximum loan amount you can cover is if there is an interest rate increase or a life event like a job loss so that you will be able to keep making payments without interruption, no matter what macro and micro economic factors arise.
As always, keep track of your credit and sign up for a free weekly credit report to make sure your credit score stays healthy, as you will likely be carrying a balance for years with a home equity loan.
The bottom line
Home equity loans and HELOCs come with the risk of losing your house if you miss multiple payments. During times of economic uncertainty, and with the Fed poised to continue increasing rates, it's critical to make sure your monthly budget can handle fluctuations to your second mortgage payment if your payments increase. As a homeowner, you have to weigh the pros and cons of collateralizing a loan with your property. And as with any loan, it's always smart to shop around with multiple lenders and compare rates and fees to make sure you're receiving the most favorable terms available.
