In this article
- Risks of home equity loans
- When to avoid a home equity loan
- How to protect yourself
- FAQ
Key takeaways
- Despite their advantages, home equity loans come with risks: You could lose your home if you miss payments, end up owing more than your home’s worth and harm your credit score.
- Using home equity loans for purposes like monthly expenses, buying a car, paying for a vacation, or investing in real estate is generally not advisable.
- Instead, these loans should be used for home improvements or consolidating debt with a lower interest rate.
- Ways to protect yourself from the risks of home equity loans include not borrowing more than needed, sticking to a budget, and monitoring your credit score.
Home equity loans can help homeowners take advantage of their home’s value to access cash easily and quickly. Borrowing against your ownership stake could be worth it if you’re confident you’ll be able to make payments on time, especially if you use the loan for improvements that increase your home’s value.
However, there are several caveats to consider regarding these loans. While all loans come with some level of risk, home equity financing is a type of secured debt—secured by your home, to be precise—which means you should approach it with an additional layer of caution.
Here we outline the leading hazards of tapping your home equity, and how to avoid (or at least minimize) them.
Risks of home equity loans
There are two main types of loans that use your home as collateral: home equity loans and home equity lines of credit (HELOCs). Both involve similar risks.
Your home is on the line
The stakes are higher when you use your home as collateral for a loan. Unlike defaulting on a credit card — whose penalties amount to late fees and a lower credit score — defaulting on a home equity loan or HELOC could allow your lender to foreclose on your home. There are several steps before that would actually happen, but still — it’s a possibility.
Before you take out a home equity loan, check your budget. Crunch your household income numbers against your monthly expenses to see if you can afford the home equity payment.
Home values can change
With elevated mortgage rates and high home prices constantly in the news, the idea of a drop in property values seems hard to imagine nowadays. Yet it can happen, and even has in a few overheated real estate markets around the country.
If your home’s value declines and you’ve got both a primary mortgage and a home equity loan, you could end up owing more on your residence than it is worth — a situation known as negative equity. Also known as being underwater, it can be a real problem, especially if you try to sell your home.
If you have a HELOC and the value of your home tumbles dramatically, your lender could cap your balance — that is, reduce the amount of home equity you can borrow against. And if your home is underwater, your HELOC will probably be frozen, and you will no longer be able to withdraw funds from it.
Interest rates can rise with some loans
While loan terms vary by lender and product, HELOCs generally have adjustable rates, which means that payments increase as interest rates rise.
“The interest rate on a home equity line of credit is often tied to the prime rate, which will move up if there’s inflation or if the Fed raises rates to cool down an overheating economy,” says Matt Hackett, chief operating officer at mortgage lender Equity Now.
Because interest rates are unpredictable, HELOC borrowers could pay much more than they originally signed up for—especially if rates rise quickly, as they did in 2022. In the worst cases, monthly payments could become unaffordable.
Home equity loans, on the other hand, typically have fixed interest rates for the life of the loan, so you’ll know exactly how much your monthly payment will be for the entire loan term.
Paying the minimum could make payments unmanageable down the line
While you can usually pay back whatever you borrow at any time, many HELOCs require interest-only payments during their draw period (when you’re allowed to access the funds). Tempting as that is, if you only make these minimum payments, you won’t make any progress in paying down your outstanding balance.
After the draw period expires, borrowers enter the HELOC’s repayment period: They start repaying both principal and interest and can no longer use the credit line. If you borrowed a large amount during the draw period and only made minimum payments, you might experience sticker shock once the principal balance is added to your monthly bill.
Your credit score can drop
Opening a home equity loan can also affect your credit score. Your credit score is made up of several factors, including how much of your available credit you’re using.
Depending on your financial situation, a large home equity loan to your credit report can negatively impact your credit score by increasing the amount of available credit you’ve utilized. That could make it harder to qualify for other loans in the immediate future. For example, getting a home equity loan right before buying a car could mean a higher interest rate on the auto loan (because your score is lower, making you look less creditworthy) or even a rejection entirely.
In the long run, having a home equity loan and making regular monthly payments can strengthen your credit by showing you can handle long-term debt responsibly. Just be aware of the short-term drop you’ll likely see.
When to avoid a home equity loan
While you can use home equity loan funds for anything, that doesn’t mean you should. A home equity loan could be a good idea if you use the funds to make home improvements or consolidate debt with a lower interest rate. However, it is a bad idea if it will overburden your finances or only serve to shift debt around.
If you’re thinking of taking out a home equity loan, it’s best to avoid using it in the following scenarios:
To help solve monthly cash flow problems
It’s generally not a good idea to resort to a home equity loan if you need funds to help resolve day-to-day money shortfalls in your household or living budget, says Steve Sexton, financial consultant and CEO of Sexton Advisory Group, based in Temecula, Calif.
After all, a home equity loan still needs to be repaid, and failure to keep up with payments could send you deeper into debt. “If you’re hoping it will help your cash flow problems, it will likely do the opposite if you don’t have a structured plan to pay back the loan,” says Sexton.
To buy a car
Using home equity loans to purchase a new car is not a wise idea. Sexton describes this as simply moving debt from one place to another without solving the root financial issues, typically poor spending habits or overspending.
A car is a depreciating asset. “There is no long-term value—and if you lose your job and cannot make the payment, you’re looking at a home foreclosure.— Steve Sexton, financial consultant and CEO of Sexton Advisory Group
To pay for a vacation
“Using home equity loans to fund leisure and entertainment indicates you’re spending beyond your means,” says Sexton. “Using debt to fund your lifestyle only exacerbates your debt problem.”
If taking out a loan to pay for a holiday would stretch your monthly budget — and put your home at risk — it’s better to hold off on the loan and start a vacation-specific savings fund instead.
To invest in real estate (or anything else)
Investing is always a laudable activity, but going into debt to invest is debatable. Real estate is particularly speculative and, more importantly, highly illiquid, meaning it cannot quickly be sold for cash without a loss in value. Even if your real estate investment goes well, it can take years to realize any appreciation, and it will take time to get your money back out in order to repay your home equity loan.
The one exception might be to use home equity to buy an adjacent property or lot, which can enhance your home’s value.
To pay for college
This one is not so much a total avoid as a consider-it-carefully. True, going to college can be considered an investment in terms of skills and careers. Using home equity loans can be a smart strategy, especially HELOCs, which are tailor-made for expenses incurred in installments over a long time period. You can just withdraw what you need for that year’s or that semester’s tuition and only incur interest on that particular amount. You or your child can also start paying it back right away, rather than being hit with a mountain of debt after graduation.
But there are other ways to pay for college that don’t require risking losing your home. What’s more, interest rates on federal student loans are lower than those on HELOCs and home equity loans.
How to protect yourself from the risks of home equity loans and HELOCs
If you do take the home equity loan plunge, go about it intelligently.
Don’t borrow more than you need
Don’t just automatically tap your equity to the max. Try to calculate exactly how much you’ll need — perhaps with a bit extra, depending on the expense — and limit your draw to that.
Before you apply, it’s a good idea to crunch numbers with a financial advisor to see how much you can afford to borrow and comfortably repay each month.
Create and stick to a budget
When you get your home equity loan or HELOC, it’s easy to feel like you have a huge cash pool. That makes it easier to spend superfluously.
When you get your loan, create a new budget and stick to it. Make sure that the budget includes your new loan payment so you can make good progress on paying down the balance.
If you opted for a HELOC, make sure that the budget includes payments for both interest and some principal. Even if interest-only payments are allowed, paying down the principal during the draw period can save you a lot of money (in smaller interest charges) and avoid a nasty payment spike when the draw period ends.
Refinance your HELOC into a fixed-rate HELOC
If you sign up for a HELOC with an adjustable rate, you can always consider converting to a fixed rate during your draw period or after it ends (assuming the lender allows it — another thing to look for when comparing offers). Many lenders offer fixed-rate HELOCs and HELOC conversions. This gives you a chance to pay off or pay down your balance while the rate is locked.
Or you could look into refinancing the HELOC into a fixed-rate home equity loan. That will protect you from unexpected shifts in interest rates, which can increase your monthly payments. Just be sure to read the fine print of your loan to make sure there isn’t a prepayment penalty.
Monitor your credit score
Keep an eye on your credit score and how your home equity loan impacts it. Adding a new, large debt to your report will likely drop your score in the short term.
Keep watching your score to see how it changes as you make payments or draw additional funds from your HELOC. If it drops significantly, consider pausing HELOC withdrawals or stepping up your efforts to pay off the loan.
FAQ
If your home suddenly needs a plumbing overhaul, a replaced septic system or a new roof, it can be hard to come up with thousands of dollars on short notice. Using a home equity loan to fund emergency repairs can make sense, especially since you are maintaining your home’s value by making the repairs.
You can use a home equity loan to pay for home improvements — in fact, that’s what they’re most commonly used for. Using your home equity to fund renovation projects can make it a better place to live while also boosting the value of your property.
Your home equity can be a source of financing to purchase land, whether you’ll build a home on it or not.
When you need to access cash and a home equity loan is not a viable option, there are alternatives. The options include:
- Personal loan
- Credit cards
- Cash-out refinance
If you use a home equity loan to fund improvements to your home, the interest payments you’ve made on the loan may be tax deductible.
Bottom line on home equity loan risks
Some home equity lenders tout your ownership stake as a treasure that’s just sitting around, begging to be tapped. But the reality is that home equity loans are just that: loans. They create a debt that must be paid back, and they come with fees and interest, which can ultimately cost you thousands of dollars on top of your initial loan amount.
“In 2020, 2021 and the first half of 2022, many clients took out home equity loans to remodel and sell their property to create a larger profit,” Sexton says. Since interest rates have risen and the real estate market has slowed, those quick turnaround days are largely gone.
Still, using home equity as a long-term investment in your home to enhance its worth can still be a sound strategy. Before committing to a home equity loan, consider your budget and compare home equity rates, terms and fees from a variety of lenders to see how much it could cost you.
