How to avoid the risks of home equity loans
Home equity loans allow homeowners to take advantage of the home’s worth and get cash quickly and easily. If you are confident that you will be able to pay your monthly payments on time and if the loan is used for home improvements that increase your home’s value, borrowing against your home equity may be worthwhile. If you default on your payments, there are many risks. Before you decide to get a home equity loan, be sure to consider these risks and the terms of your lender.
Home equity loans can be risky
All loans have some risk. Home equity loans, however, are tied to your home. This means that you need to be extra cautious when approaching them. Here are some possible outcomes:
Some loans can have higher interest rates.
Two main types of loans use your home equity to collateral: home equity loans (HELOCs) and home equity lines credit (HELOCs). Although loan terms can vary depending on the product and lender, HELOCs have generally adjustable rates. This means that your payments will increase as interest rates rise.
“The prime rate is what determines the interest rate on a home equity loan,” Matt Hackett, Operations Manager at Equity Now, says.
HELOC borrowers may end up paying more because interest rate increases can be unpredictable.
Fixed interest rates are typically used for home equity loans. This means that you will know how much your monthly payments will be for the entire term.
Solution: You can convert your HELOC balance to a fixed rate during the draw period, or you could look for a fixed home equity loan. Fixed-rate HELOCs are available from some lenders. This allows you to pay off your balance or reduce it while the rate remains locked.
Your home is at risk
Your home is a collateral asset for a loan, so the stakes are even higher. You could lose your home if you default on a loan, or home equity loan.
Do your research before you apply for a home equity loan. Do you have enough income to pay the monthly payments? Are you able to afford them if your income changes? If so, home equity loans may be the right option for you.
Solution: Discuss your goals with a financial adviser about whether a loan to fund home equity can help. A financial advisor can help you analyze the numbers and help you make informed decisions based on your projected and current financial situation.
How can value rise or fall?
The real estate market is finally cooling down after two years of steadily rising home prices amid a pandemic and limited supply of homes for sale.
In an attempt to reduce inflation, the Federal Reserve increased the benchmark interest rate seven more times in 2022. In turn, the benchmark interest rate increases set the stage to increase consumer borrowing rates, including mortgage interest rates. Buyer enthusiasm was dampened by the higher cost of borrowing and the resulting higher monthly mortgage payment. The result is that home prices have been declining in recent years and some areas even falling.
Solution Do not borrow more than you have to. You can make your home more valuable by using the loan funds.
The minimum payment could lead to unmanageable payments down the road
HELOCs often require you to make interest-only payments for the first ten years or the draw period. This is when you can access the credit. You won’t be able to pay the principal if you make only these minimum payments.
Borrowers enter a repayment phase after the draw ends. They have to pay principal and interest, and they can no longer draw from the credit line. You might feel sticker shock if you borrowed large amounts during the draw period but only made minimal payments.
Solution Keep track how much you borrow and plan to repay it. Take into account both principal and interest payments.
Credit scores can fall
Your credit score can be affected by a home equity loan. Credit score is a combination of many factors. These include how much credit you have available. A large home equity loan can have a negative impact on your credit score.
You may be able to improve your credit score by taking out a home equity loan and paying regular monthly repayments.
Solution: Regularly check your credit score. You can then monitor the impact of your home equity loan on your credit score.
How to get rid of a home equity loan
Home equity loans are secured by your home. It is important to weigh all the benefits and drawbacks of this type of borrowing. If you plan to use the money to improve your home or consolidate debt, a home equity loan may be a good option. A home equity loan can be a bad idea if you are worried about your finances and want to move debt around.
It’s best not to use a home equity loan in these situations if you are considering taking one.
- To solve monthly cash flow issues – A home equity loan is not a good option if the money is being used to resolve daily money problems in your household or to improve your living expenses, according to Steve Sexton, financial advisor and CEO of Sexton Advisory Group. Sexton Advisory Group is based in Temecula. A home equity loan must be repaid. Failure to make payments could lead to deeper debt. Sexton says, “If you think it will improve your cash flow problems it will probably do the exact opposite.”
- To purchase a car – Using home equity loans to buy a new car is not a smart idea. Sexton refers to this as moving debt from one location to another, without solving the root financial problems. This is often due to poor spending habits and overspending. Sexton says that a car is a declining asset. “There is no long-term worth. If you lose your job or cannot pay the monthly payment, you might be looking at home foreclosure.”
- To fund a vacation. Sexton says that using home equity loans to finance leisure and entertainment is an indication you are spending beyond your means. “Using debt to finance your lifestyle only makes your problem worse,” Sexton says.
- To finance college – While going to college is a smart financial investment, using a home equity loan for the payment can be risky. You don’t have to lose your home to pay for college. There are other options. Consider these payment options if you are thinking about college for yourself and your family members. Federal student loans have lower rates than HELOCs or home equity loans.
- To pay off your credit card debt or other debt – While a home equity loan is more affordable than credit cards or other forms of debt it doesn’t make sense to use it to pay off other debt or credit cards. This is especially true if you borrow more than you can on the equity loan. You could end up paying more on your mortgage. You’ll likely find yourself in worse shape if you don’t address the reasons you got into high-interest debt. It’s possible that you don’t pay your credit card every month and that you have to make a home equity loan payment.
- To invest real estate – Real Estate investments are highly speculative and may go up or down. It can be difficult to get your money back, even if you make a good investment in real estate.
Alternatives to a Home Equity Loan
There are other options if you need cash but a home equity loan is not an option. There are many options:
- Personal loan: Obtaining a personal loan is often easier and funds are usually available within days. Although you might not be able access as much money with a personal loan, you can still get a home equity loan.
- Credit cards It depends on how much you have to spend, but a credit card might be an option. Many credit cards these days have high interest rates. If you are considering a credit card, make sure to shop around for one that has a 0 percent interest rate. Make sure you pay off the entire balance before the introductory period ends.
- Refinance with cash-out: A new mortgage is one that you take out on your property for more than what you owe. You would receive the extra money as a lump sum.