Home prices are rising, but home equity levels are rising too. Given the ongoing bites of inflation, this could be the ideal time, and many people are doing just that. According to the Federal Reserve Bank of New York, the size of Heloc (Home Equity of Credit), which has bulged at $9 billion in the fourth quarter of 2024, will win a $9 billion balloon in the fourth quarter of 2024.
If you are confident that you can process your payments and plan out funds that will improve your property or your net worth, borrowing on shares in your homeownership is wise. However, before you rush to apply, there are some important things to consider. Every loan carries some risk, but home equity finance is, to be precise, a type of secured debt your home is responsible for. This means that you need to approach it with more care.
Here is the risk of tapping on fairness in your home and how to avoid (or at least minimize) them.
Home Equity Loan Risk
There are two basic borrowing tools that use your home as collateral. Home Equity Loan and Home Equity Credit (HELOCS). Not that, but they carry similar types of risks.
Your home is on the line
Using your home as collateral for a loan will increase your interest. Unlike credit card defaults, where fines amount to deferred fees and lower credit scores, Home Equity Loans or HELOC defaults allow lenders to seize themselves at home. There are a few steps before it actually happens, but it’s still possible.
Understand all the requirements before taking a Home Equity Loan. Compare your household income with monthly expenses to see if you can really afford to pay. Remember: If you still have a mortgage, you are responsible for paying back two loans.
The value of the home can change
With rising mortgage rates and high home prices constantly being news, the idea of a decline in real estate value seems difficult to imagine these days. But it can happen, and it is already in some overheated real estate markets around the country, like Florida and Texas. Furthermore, economic recession (or one fear), extreme weather events, and even slower job markets, can potentially affect the value of a home.
Using home equity essentially reduces home ownership. This can be a real problem if the value of the property decreases as you may end up paying for more than your home – a situation known as negative fairness. Being underwater (as it is known) can hinder your ability to sell your home or refinance your mortgage.
Interest rates can rise on some loans
Lending terms vary by lender and product, but HELOCs generally have adjustable interest rates. This means that payments increase as interest rates rise.
“Home Equity credit line interest rates are often tied to the prime rate, which rises when there is inflation or when the Fed raises interest rates to cool the overheating economy.”
Interest rates are unpredictable, so HELOC borrowers can pay much more than they originally signed up, especially when interest rates rise rapidly, such as in 2022. In the worst case scenario, you may not get a monthly payment.
Home equity loans, on the other hand, usually have a fixed interest rate, so you can know exactly how much your monthly payments are over the entire loan period.
Payments can skyrocket
Normally you can repay anything you borrow at any time, but many HELOCs allow you to pay interest only during the draw (when you actually access the funds). It’s attractive. If you only make these minimum payments, you will not make any progress by paying back your outstanding balance.
After the draw period that normally lasts for 10 years has ended, the HELOC repayment period will begin. The borrower will no longer be able to use the line of credit, but will need to begin repayment of both the principal and interest. If you withdraw a large amount during the draw period and only make minimum payments, you may be subject to a sticker shock if your main balance is added to your monthly bill.
“Many people say, ‘I’m going to take out Helock, and it’s cheap at first with just interest,” says Yechiel Zeilingold, lender at FM Home Loans, a Brooklyn, New York-based mortgage lender. “And ten years later, everyone might have a hard time coming up with that money.”
Your credit score may drop
Opening a home equity loan can also affect your credit score. Your credit score consists of several factors, including the amount of credit available you are using.
Depending on your financial situation, a large home equity loan to your credit report can negatively affect your credit score by increasing the amount of available credit you have used. That could make it difficult to qualify for another loan in the near future. For example, getting a home equity loan just before you buy a car could mean a high interest rate on your car loan (because your score is low and your credit value will drop) or even reject it altogether.
In the long term, you can strengthen your credit by having a home equity loan and making regular monthly payments to demonstrate that you can handle your long-term debt responsibly. Beware of the short-term declines you are likely to see.
The debt burden increases
Of course, the loan increases your debt burden and demands on your income. But by harnessing the fairness of your home, you essentially drain your interest in your ownership and turn your valuable assets into costly obligations.
Nowadays, people often take out their home equity loans or HELOCs to pay off other debts. For example, if the other debt is a double-digit APR credit card balance, this makes sense. Or they charge a higher interest rate than a home equity loan. “Many people think it’s a band-aid situation where they can wrap their debts into a monthly (HELOC) payment,” says Christie Vance, president of New American Funding, a California-based mortgage lender. “They’re not getting rock bottom fees, but they can lower their monthly debt,” she adds, and when interest rates drop, the same homeowner can choose to refinance their cash-out, pay off that HELOC, and wrap it in a major mortgage.
However, be careful not to start running the balances on these cards again after you have paid them back. Financial consultant Steve Sexton and CEO of Sexton Advisory Group, based in Temecula, California, explains that they simply move their debts from one location to another without solving underlying financial and spending issues.
If you are not using a home equity loan
Between yours can Use a Home Equity Loan Fund for anything. Should. Home equity loans can imagine a good idea when using funds to improve your home or consolidate your debts at lower interest rates. But whether it will help you to cover your financial burden or change your debt is a bad idea. It is best to avoid using it in the following scenarios:
To meet daily expenses
Sexton said relying on a home equity loan is generally not a good idea if you need funds to solve daily financial shortages in your family and living budget.
Ultimately, you will need to pay back your home equity loan and keep up with your payments and you will be able to deepen your debt. “If you want it to help with your cash flow issues, if you don’t have a structured plan to pay off the loan, you’ll probably go against it,” he points out.
Buy a car
It’s not wise to use your home equity loan to buy a new car.
In fact, with all the high prices, discretionary items are not wise. These things tend to depreciate assets. There’s no long-term value, says Sexton. And you will still pay them even after their value drops.
However, such purchases can be justified. If they are part of a major renovation: upgraded appliances in an expanded kitchen or new bathroom, for example, the construction of a backyard deck. In this case, they are more like an investment and are part of the overall improvement that will increase the value of your home.
Cars are depreciable assets. There is no long-term value. If you lose your job and can’t pay, you’re looking at home seized.
– Steven Sexton, financial consultant and CEO of Sexton Advisory Group
Pay for holidays and holidays purchases
If you are taking out a loan to pay your leave and extending your monthly budget and putting your home at risk, it’s better to start a holiday-specific savings fund in the wake of the loan. The same applies to holiday costs. While the interest rates on home equity loans are lower than credit cards and personal loans, it is extremely dangerous to use your home stocks to shop and entertain during the festive season.
“Funding leisure and entertainment using a home equity loan shows you’re spending beyond your means,” Sexton says. “Using debt to fund your lifestyle will only exacerbate the debt problem.”
Invest in real estate (or something else)
Investing is always a commendable activity, but getting into debt for investment is controversial. Real estate is particularly speculative and, more importantly, highly illiquid. This means you can’t sell quickly without compromising your value. Even if your real estate investment is on track, it can take years to understand your appreciation. It also takes time to get back money to pay back your home equity loan.
One exception is to use home equity to purchase adjacent properties or lots, as extensions definitely increase the value of your home.
Paying to the university
This isn’t that important. Certainly going to college can be seen as an investment in terms of skills and career. Also, using a home equity loan could be a smart strategy, especially for Helocs. In particular, it is adjusted to suit the costs incurred in installments over a long period of time. You can withdraw what you need for that year and semester tuition fees, and only bring interest to that particular amount. You or your child can start paying it off immediately, rather than bumping into a pile of debt after graduation.
However, there are other ways to pay to a university that doesn’t need the risk of losing your home. Additionally, the interest rates on federal student loans are lower than those on Helocs and Home Equity Loans.
How to protect yourself from the risks of a home equity loan
If you want to get a Home Equity Loan Plunge, go intelligently.
Don’t borrow more than you need
Do not automatically tap capital to maximum. Depending on your costs, try to calculate exactly what you probably need a little extra and limit your loan to that. If you’re getting a HELOC, find out how to timing your draw in advance. Before applying for a product, we recommend that you calculate the numbers together with your financial advisor to make sure you can afford to borrow each month and pay off comfortably.
Create a budget and stick
Getting a Home Equity Loan or HELOC makes it easy to feel like there’s a huge cash pool. This makes it easier to spend extra. Having a large credit line in particular is as attractive as a huge credit card.
Once you have the loan, create a new budget. This includes payments for new loans and can make good progress by paying off your balance. If you choose HELOC, make sure your budget includes payments for both interest and the loan itself. Even if you are allowed to pay interest only, paying back the principal during the draw period can save you a lot of money (low interest), avoiding troublesome payment spikes when the draw period ends.
“It’s a mortgage. It’s not a credit card. It’s not a personal loan,” says Jr Younathan, vice president of state production managers at the Bank of California and Trust, which offers Helocs. You want to be keen to pay it on your major mortgage.
That doesn’t mean that HELOC cannot work as a reserve fund. If you can afford to pay an annual fee to keep your line of credit open, Younathan says, “Leave it there until there is an urgent or additional fee.” According to Experian, homeowners with HELOC balance collectively use just a third (37%) of the credit lines that hold the remaining lines for future needs.
Refinance HELOC with fixed interest rate HELOC
If you sign up for HELOC at an adjustable rate, you can always consider converting it to a fixed rate during or after the draw period (assuming your lender allows it – you can look for another one when comparing offers). Many lenders offer fixed rate HELOC and HELOC conversions. This gives you the opportunity to repay or repay your balance while the rate is locked.
Alternatively, you can refinance your HELOC with a home equity loan. This will help you protect you from unexpected changes in interest rates and increase your monthly payments. Be sure to read the fine print of your loan to ensure there are no advance payment penalties.
Monitor your credit score
Be aware of your credit score and how your home equity loan will affect you. Adding a large amount of new debt to your report can reduce your score in the short term. Keep looking at your score, see how it changes when you pay, or raise additional funds from HELOC. If it drops significantly, consider suspending Heloc withdrawal or increasing your loan repayment efforts.
Shop for the best prices and conditions
Don’t settle for your first home equity loan or the Heloc offer you receive. Compare rates, conditions and rates from at least three lenders to ensure you get the best deal. Some lenders either waive the cost of closing a certain amount of loan or offer promotion fees. Even small differences in interest rates can lead to significant savings over the lifespan of your loan.
Is Home Equity Loan a Good Thing for You?
Some home equity lenders beg your ownership interests to be tapped, just as a sitting treasure. But the reality is that home equity loans are exactly that: loans. They create debts that they have to pay back, and they could end up costing you thousands of dollars on top of your initial loan amount.
Despite these risks, using home equity as a long-term investment in your home to increase its value can be a healthy strategy. Before committing to a home equity loan, consider your budget and compare interest rates, terms and rates from various lenders to see how much it costs.
Home Equity Loan Risk FAQ
Additional Reports by Maya Dollarhide
