Risks of a Home Equity Loan

A home equity loan is money you can borrow based on the equity you’ve built in your home. Many homeowners use these options to consolidate debt, make home repairs, or finance large purchases such as investment properties.

Home equity loans and lines of credit have lower interest rates than unsecured loans such as credit cards. However, one of the biggest risks of this type of loan is that you'll lose your home if you can't pay back your debt and your house goes into foreclosure.

It’s important to consider both the benefits and potential risks involved with home equity loans. Doing so can help you reason through financial circumstances when it may or may not be a sound idea to take on this additional debt.

What Can You Use a Home Equity Loan For?

Home equity loans and HELOCs are financially secured by how much of your home you own. If you have good credit and equity, you can use these loans to pay off high-interest debt, renovate your home, fund college tuition, or pay medical bills.

Types of Home Equity Loans

There are two primary ways to take out a home equity loan: a loan or a line of credit. Depending on your financial goals, each option has risks and benefits.

Home Equity Loan

A home equity loan is a second-position loan taken out after the initial mortgage, with closing costs. A lump sum is dispersed and paid back monthly, usually with a fixed interest rate.

It offers less flexibility, lowers your overall financial liquidity, and is closed-ended (no revolving balance). It tends to have a higher interest rate than a HELOC, but a lower rate than a traditional loan. 

Home equity loans are ideal for borrowers with predictable income looking to finance larger, long-term expenses.

Home Equity Line of Credit (HELOC)

A home equity line of credit (HELOC) allows you to borrow against your home's equity up to a specific limit. It is a revolving credit option, but you'll have to pay back what you use, plus interest. It's like a credit card on your home, including the variable interest rates.

A HELOC gives you the option to obtain funds to consolidate debt and make large purchases. It also has a lower interest rate than a home equity loan (but still higher than a traditional mortgage). It may have a prepayment penalty if you close the line early.

The equity in your home will secure your HELOC. If you default on payments, your lender can take ownership of your property and sell it for the loan balance plus interest and other costs.

Risks of Borrowing Against Your Home Equity

It’s important to note that while the interest rate on a home equity loan is lower than many other financing options, foreclosure is a threat if you default. You’ll also need to take a lump sum of cash and will be responsible for repaying the full amount. That’s why it’s important to carefully consider the risks before signing on the dotted line.

You’ll Increase Your Debt

While lenders may allow up to 43%, the Consumer Financial Protection Bureau recommends that homeowners maintain a debt-to-income (DTI) ratio of 36% or less. A home equity loan may raise your DTI, reducing future lending options.

You’ll Put Your Home at Risk

When you take out a home equity loan, the lender will ask you to list the property you're borrowing against as collateral. If you default on your loan, the lender has the right to foreclose on your property and take ownership of it.

You Can Hurt Your Credit Score

When you default on a home equity loan, you are not just hurting your credit score, but also the credit score of your co-borrower if you have one. Missed payments can damage your credit score, negatively affecting future financing options.

Your Home’s Value Could Drop

If you don't pay your home equity loan back on time, you could lose your home to foreclosure. This can lower your own home’s value and the value of the homes in your neighborhood.

Interest Rates Could Rise

The interest rates for home equity loans are higher than standard mortgages because these lenders are not the first in line to your collateral if something goes wrong. In addition, interest on your loan will accumulate over time. Keep track of your payments so you don't end up with a large balloon payment at the end of your term.

You May Incur Additional Costs, Penalties, and Fees

If you are borrowing against your home equity, you’ll need to have your home appraised. The cost of a home appraisal varies depending on the type of property and location. Generally, the more valuable the property, the higher the appraisal cost. For a single-family home, expect to pay from $300 to $500.

Home equity loans also come with closing costs. These are usually deducted from the amount of money offered by the lender, but can range from 2% to 6%.

Is a Home Equity Loan Right for You?

There are numerous benefits of using a home equity loan. One benefit is that there often is no money due at closing, saving you significant money upfront. Another benefit is that these loans allow for flexible repayment terms, which can help you avoid financial hardships. You might benefit from a home equity loan if you need a considerable sum and can afford the interest or extra payments but don't want to take on additional unsecured, high-interest debt.

Home equity loans may be a practical idea if you:

• Plan on living in your current home for a while
• Want to consolidate debts or pay off high-interest loans
• Need to make major home improvements
• Need to finance emergency expenses (such as a hospital bill)
• Are sure you can achieve the repayment timeline

Home equity loans may not be a financially sound idea if you:

• Are struggling to make ends meet
• Plan on moving or refinancing soon
• Have unpredictable income
• Have a low credit score
• Are facing legal issues (such as going through a divorce)
• Need to borrow a smaller amount (such as for a vacation)

The option that makes the most sense for you will depend on many factors. However, since your home is at risk, if you have other methods for accessing the money you need, it may be better to explore those first. If you are unsure, take some time to carefully consider your options. Wait until your credit score and financial situation improve, and talk to a financial advisor before borrowing against your home.

Frequently Asked Questions (FAQs)

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