Home Equity Loan Risks and How to Avoid Them

Home equity loans help homeowners capitalize on the value of their homes and gain access to cash easily and quickly. If you’re confident that you’ll be able to make your payments on time, it’s worth borrowing against your home’s assets, especially if you’re using the loan for improvements that add value to your home. However, late payments come with some risks. Consider these risks and lender terms before deciding to take out a home equity loan.

Home equity loan risk

All loans carry some degree of risk, but the fact that home equity loans are tied to a home means that they should be approached with additional caution. What can happen is:

Interest rates may rise on some loans

There are two main types of loans that use home equity as collateral. Home Equity Loan and Home Equity Line of Credit (HELOC). Loan terms vary by lender and product, but HELOCs generally have adjustable interest rates. In other words, payments increase when interest rates rise.

“The interest rate on home equity lines of credit is often tied to the prime rate, which rises when inflation hits or when the Fed raises interest rates to cool an overheated economy. ,” said Matt Hackett, operations manager at mortgage lender Equity. now.

HELOC borrowers may end up paying much more than they originally agreed to because interest rate increases are unpredictable.

Home equity loans, on the other hand, usually have a fixed interest rate for the life of the loan, so you know exactly what your monthly payment will be for the entire life of the loan.

Resolution: Convert your HELOC balance to fixed rate or look for a fixed rate home equity loan during the drawing period. Some lenders offer fixed rate HELOC and HELOC conversions. This gives you the opportunity to pay off or reduce your balance while the rates are locked.

your home is online

The stakes are high when you use your home as collateral for a loan. Unlike a credit card default, where the penalties are late fees and a low credit score, defaulting on a home equity loan or his HELOC means you could lose your home.

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Before you take out a home equity loan, do your homework. Whether you have enough income to make regular payments, whether you can afford to pay if your income changes, and whether a home equity loan is the best solution for your financial needs Ask yourself.

Resolution: Talk to your financial advisor about whether a home equity loan can help you reach your goals. Advisors can help you look at the numbers and make informed decisions based on your current and projected financial situation.

how value goes up and down

After two years of steadily rising home prices amid the pandemic and limited inventory of homes for sale, the real estate market has finally calmed down and started to cool.

The Federal Reserve has raised the benchmark interest rate seven times in 2022 to keep inflation in check. The hike in benchmark interest rates set the stage for higher consumer borrowing rates, including mortgage rates. Buyer enthusiasm cooled as borrowing costs skyrocketed, resulting in higher monthly mortgage payments. As a result, house price growth has slowed recently and even fallen in some areas.

Resolution: Don’t borrow more than you need. Even better chances: Use the loan funds to make improvements that can increase the value of your home.

Paying the minimum can make payments unmanageable

Many HELOCs require interest-only payments for the first 10 years or any withdrawal period that allows access to the credit. If you make only these minimum payments, you will not be able to pay the principal.

Once the withdrawal expires, the borrower enters a repayment period and must pay both principal and interest, making the credit facility unavailable. If you borrow a lot during the drawing period and only make the minimum payment, you may experience sticker shock when the drawing period ends and the principal balance is added to your bill.

Resolution: Make sure you have a repayment plan in place, keeping track of how much you owe and factoring in both interest and principal payments.

Your credit score may go down

Opening a home equity loan can also affect your credit score. Your credit score is made up of several factors, including the amount of credits available. Adding a large home equity loan to your credit report can negatively affect your credit score.

Taking out a home equity loan and making regular monthly payments can also have a positive impact on your credit score.

Resolution: Check your credit score regularly. That way, you can monitor the impact of home equity loans on your score.

When to Avoid Home Equity Loans

Since a home equity loan secures the loan against the home, it’s important to carefully weigh the pros and cons of this type of borrowing. If you want to use the funds to renovate your home or consolidate your debt at low interest rates, a home equity loan is a good option. However, a home equity loan isn’t recommended if it’s too taxing on your finances or you just want to pass on the debt.

If you are considering taking a home equity loan, we recommend avoiding it in the following scenarios:

• Helps solve monthly cash flow problems – It’s generally not a good idea to resort to a home equity loan if you’re only using your money to meet the daily shortfalls of your household or living budget.Temecula, Calif.-based group. After all, the home equity he loan still has to be paid off, and falling behind on payments can make the debt even more serious. “If it’s looking to solve cash flow problems, it can have the opposite effect if you don’t have a structured plan to pay off the loan,” says Sexton.

• to buy a car – Taking a home equity loan to buy a new car is also unwise. Sexton explains this as simply moving debt from one place to another without actually solving the underlying financial problem. “Cars are depreciating assets,” says Sexton. “It has no long-term value. If I lose my job and can’t pay my bills, I’m considering a foreclosure on my home.”

• to pay for vacation – “Using a home equity loan to finance leisure and entertainment shows that you are spending more than you can afford,” says Sexton. “Using debt to finance your lifestyle only exacerbates the debt problem.” We recommend that you put on hold and start a vacation-focused 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 can be risky. There are other ways to pay for . If you are thinking of going to college for yourself or someone in your family, rather than using home equity his loan to pay for college, consider one of these payment methods. Please give me. Additionally, federal student loan interest rates are lower than HELOC and home equity loan rates.

• To pay off credit card and other debts – It is true that interest rates on home equity loans are lower than credit card and most other debt, but that doesn’t mean using a home equity loan to pay off credit card or other debt is a good idea. not necessarily. This is especially true when maxing out on a home equity loan. There is a risk that the mortgage will turn upside down. If you haven’t addressed the factors that led you into high-interest debt, you could end up in an even worse situation. You may find that your monthly credit card payment has not yet been completed. On top of that, there will also be home equity loan payments.

• to invest in real estate – Real estate investments are highly speculative and can go up and down. Even with a successful real estate investment, it can be difficult to get your money back to pay off your mortgage.

Home Equity Loan Alternatives

If you need access to cash and a home equity loan isn’t a viable option, there are alternatives. Options are:

• Personal loan: Personal loans are easy to obtain and funds are often available in just a few days. With a personal loan, you may not have access to as much cash as with a home equity loan.

• credit card: You can also use a credit card depending on the amount you need. However, interest rates on many credit cards have skyrocketed recently. So, if you are considering using a credit card, try looking for a card with 0% of his referral fee. And make sure to pay the balance in full before the referral period ends.

• Cash out refinancing: A cash out refinance is a brand new mortgage where you borrow more money on your home than you owe on it. The extra money you owe is provided in cash lump sums.

Conclusion

Some mortgage lenders view equity as money waiting to be spent, but the reality is that a home equity loan is just a loan. That’s money that must be repaid, with fees and interest that can end up costing thousands of dollars on top of the original loan amount.

That’s not to say that the risk of a home equity loan isn’t worth it. In some cases, especially when using the funds to renovate a home, a home equity loan is a good idea.

“In 2020, 2021 and the first half of 2022, many of our clients have taken home equity loans to renovate and sell their properties for greater returns,” Sexton said. “However, interest rates have risen significantly in 2023 and property market values ​​have fallen. Taking a home equity loan to renovate and sell a home is a risky proposition.”

Before signing up for a home equity loan, consider your financial situation and compare home equity interest rates, terms and fees from various lenders to see how much it will cost.