Many deed holders have accumulated a lot of home equity over recent years. Financial gurus online often encourage homeowners to tap into it. After all, why not take advantage of a home’s rise in value to get cash and do something on your bucket list?
But handy as they are, home equity loans do come with risks. The personal finance decision-making professionals at Bankrate say these loans are best for upgrades to the home itself, or debt consolidation that relieves a homeowner from paying high interest on credit.
Let’s look a little deeper.
Borrowing Against Home Equity Means Staking Your Home as Collateral
Deed holders don’t just acquire a roof overhead — although that’s pretty nice to have. They also have a time-tested basis for wealth-building. As long as markets rise (and real estate normally does rise, over the long term), real estate becomes a growing source of value called home equity.
So, what’s the risk of putting that value to work?
Let’s start with the worst-case scenario — not because it’s likely to happen, but just so it’s clear. No one wants to run into trouble repaying a loan or credit line that stakes the borrower’s home. But lenders do reserve the prerogative of foreclosure. There are hurdles that the lender would need to clear first, but sometimes, foreclosure over home equity borrowing does occur.
How could it happen?
- One way it happens is by cuts in household income. Say the homeowner gets laid off, and unexpectedly runs into trouble repaying the lender.
- Or what if a local real estate market dips? Home values can and do change. Consider a scenario in which a home’s value declines and the owner has a home equity loan (a second mortgage). With two mortgage liens, could more easily get into debt that’s greater than the home’s worth.
Simply put, secured debt on a home puts the homeowner’s deed at stake. And if the homeowner goes “underwater” a lender could self-protectively cut off access to financing.
Home Equity Loans: Risks and Rewards
A home equity loan (HEL), like most people’s mortgages, often carries a fixed interest rate. That makes monthly budgeting straightforward for the whole term of the loan.
What, then, should a borrower look out for? For one thing, the loan will take a brief toll on the borrower’s credit score. That’s because of the added “credit utilization” the borrower undertakes with the loan. That could make purchases on credit harder. Over time, though, with regular monthly repayment, a HEL can raise a credit score.
What other words to the wise can we relay? It’s usually best, says Bankrate, to avoid taking out a home equity loan (HEL) in the following scenarios:
- To buy a vehicle. As a car loses value over time, it is not the kind of investment that pays for the effort, time and interest involved in borrowing against the home.
- To fund a vacation. The recommended way to do this is to set up a vacation savings fund.
- To acquire another deed. Real estate can’t easily be sold for cash to handle debts. And taking on an investment property is an inherently risky move.
- For tuition. There are ways to pay for education without putting a home’s deed at stake.
In contrast, borrowing against a home could make the most sense when the borrower needs:
- Debt consolidation. If the loan relieves a homeowner from paying higher interest on other credit accounts, it could reduce financial risk overall.
- Home improvements. If the deed holder upgrades the home and increases its value, the loan fees and interest payments could be well worth making.
- Emergency repairs. Many homeowners face major repair costs related to weather extremes. “The interest on a home equity loan is often tax-deductible,” Bankrate points out, “if the money’s used to repair, rebuild or substantially improve the home.”
Note: Don’t forget property taxes. Upgrades to a home can push up taxes along with the property value itself.
Home Equity Lines of Credit: Who’s in Control?
The market has control over the interest a HELOC borrower pays. This is in the typical scenario, with an adjustable-rate HELOC. So, monthly payments can unexpectedly rise when the Federal Reserve ratchets up the rates. Applicants can speak to their lenders about fixed-rate offerings.
And yet, in this election year, with interest rates presumably poised to drop (no guarantees!), today’s adjustable-rate HELOC applicant could come out pretty well as monthly payments dip. Of course, interest rate action sometimes takes us all by surprise. So it really pays to watch what the Federal Reserve is doing.
With a HELOC, you do have control over how much of the line you actually use, and how much you pay back, and when. You just need to be sure you make the minimum monthly repayments. With a typical HELOC, the borrower must start paying off interest early on — in the draw period, which is when the borrower uses the available credit.
Paying off more than the minimum is essential to get the loan principal down. That lowers risk for the borrower when the repayment period starts. That’s when the cash flow shuts off, and the homeowner has to include principal as well as interest in their monthly budget. At the end of the term, the borrower could owe a lump-sum repayment. In short, paying down the principal before you have to can save on interest, and avert a ballon payment crisis when the draw period is over.
Remember, too, that even a HELOC counts as second mortgage and is in the county records as such. This ties up your deed. Should you need to sell your property, you’ll need to have these liens released from your title first.
Effective Risk Management When Your Deed Is on the Line
Bankrate offers some great tips for risk management when you borrow against home equity:
- Note that any loan includes fees and interest that must be factored into repayments.
- Work out how much money you really need. Limit your debt to that amount.
- Adhere to a budget for paying down a loan balance — interest and principal.
Most importantly, Bankrate also says hopeful borrowers should consult their financial advisers to plan out what they can afford to borrow and repay monthly. It’s always important to know how a financial decision can impact your taxes as well as your risk-reward profile.
At the end of the day, using home equity to protect and bolster your home’s value can be a sound strategy — when due diligence is done. As always, that includes creating a budget, and shopping around for the best rates and terms.
Supporting References
Dan Miller for Bankrate, LLC (part of Red Ventures), via Bankrate.com: Home Equity Hazards – The Risks of Tapping Into Your Property’s Value (Apr. 30, 2024). See also Mia Taylor: How Your Home Can Pay for Emergency Repairs (Dec. 8, 2023).
Bankrate, LLC (part of Red Ventures): About Bankrate.
Deeds.com: Need to Pull Money Out of Your Home? Which Will Work – Home Equity Loan, or HELOC? (Jun. 9, 2023).
Deeds.com: HELOC – How Home Equity Lines of Credit Impact a Home’s Title (Jul. 30, 2023).
Deeds.com: The Big Tease – Look Out for Rising Interest on a Home Equity Line of Credit (Sep. 6, 2023).
And as linked.
More on topics: The importance of a clear title, Home improvement loans
Photo credits: Akshay Gupta, via Pixahive (licensed as CC0); and Mikhail Nilov, via Pexels/Canva.