What are the risks of HELOCs and home equity loans?

For many homeowners, borrowing against justice in your home is now an attractive option thanks to rising home values in the last two years. But before you take out a home equity loan or home equity line of credit, you need to make sure you understand the risks associated with home equity loans.

Read on to learn what the specific financial risks are when it comes HELOCs and home loans and how you can avoid them.

How does a home loan work?

Home equity loans allow you to borrow money against the equity you have built up in your home and provide you with a lump sum of cash at a fixed interest rate. HELOCs are also home equity loans, but they function like a revolving line of credit, meaning you can withdraw your money in several installments, and your interest rate is variable, so your monthly payments will change.

Equity loans are useful and can be cost effective ways to access cash at lower interest rates than other types of loans, such as personal loans or credit cards. For example, home equity and HELOC rates are under 7% right now, while personal loans have an average interest rate of 10.7%, according to Bankrate, a CNET affiliate. But they come with big risks, like foreclosure, that other types of financing don’t. Most homeowners use home equity loans for major living expenses such as home renovations and to consolidate other types of debt. As long as you have built up at least 15% to 20% equity in your home, lenders will typically allow you to borrow up to 85% of your home’s equity.

What are the risks of home loans?

You could lose your home.

The biggest drawback of each type home equity loan is that you must use your house to secure the loan. When you use your home as collateral to secure a loan, the bank or lender can take possession of your house to pay off if you miss payments or default on your home equity loan for any reason.

“You’re putting your home up as collateral for both a home loan and a HELOC, which means if you fail to make payments on either, you could lose your home to foreclosure,” says Robert Heck, vice president of mortgage lending at Morty, an online mortgage marketplace.

For most people, losing their house is a much more significant consequence than a lower one credit ratingwhich is why it is vital that you carefully consider whether you can repay a home equity loan over an extended period of time.

Fluctuating interest rates can break your budget.

With HELOCs, one downside to keep in mind is that they have a variable interest rates, which means you won’t have constant monthly payments. What you have to pay each month will increase or decrease with general interest rate trends. HELOC rates are affected by the prime rate, which is currently 5.5%. The prime rate is the interest rate that banks use to set lending rates, as well as the economic policy set by the Federal Reserve. So far this year, the Fed has raised interest rates four times and plans to continue raising them.

This means that your HELOC payments are likely to increase in the near future in our current economic environment. Therefore, it is extremely important to make sure that your income can comfortably absorb fluctuations in your monthly payments.

Home equity loans, on the other hand, have fixed interest rates. In a rising interest rate environment like the one we’re experiencing today, this can prove beneficial for homeowners who won’t have to worry about their interest rates — and therefore their payments — increasing.

You’ll make higher monthly payments if your rate goes up.

If interest rates remain high or rise, be prepared to continue making higher monthly payments over time with a HELOC. With expert predictions a potential recession on the horizon, it’s important to consider how secure your job is and how much of an emergency savings cushion you have should major life events occur, such as a layoff. Most financial experts recommend keeping at least three to six months of living expenses in an emergency fund if possible.

Make sure you can afford to keep making payments on both your first mortgage and your home equity loan (more commonly called a second mortgage) if your financial situation changes.

However, with a home loan, you never have to worry about increasing your monthly payments as such loans have a fixed interest rate that does not change. Currently, the average interest rate on a $30,000 home loan hovers around 7% and a HELOC is 6.5%, according to Bankrate.

Increasing debt can lower your credit score.

A HELOC is a revolving line of credit that functions as a a credit cardso maintaining a high balance over time can lower yours credit rating. While one of the benefits of a HELOC is that you can make interest-only payments during the initial drawdown period, once your repayment period begins, your monthly payments will jump because you’ll start paying down the principal as well.

Make sure you can comfortably manage such an increase within your budget. Use it Bankrate’s HELOC Calculator or home loan calculator to determine if your monthly budget can accommodate a second mortgage payment. Making consistent and timely payments on your HELOC can also positively affect your credit score.

Falling home values ​​can limit your loan.

After two years of record appreciation of housing valuesU.S. housing prices average, up to 42% since the beginning of the pandemic. This is fine as long as a recession or another catastrophic economic event causes home values ​​to fall again, in which case borrowing against the equity in your home could backfire.

When your outstanding credit turns out to be higher than the value of your home, your lender has the option to freeze or reduce your line of credit because your home can no longer serve as collateral for the loan. Having a larger loan balance than what your house is worth is known as negative equity, or when you’re “upside down” on your mortgage.

How to protect yourself from the risks of home loans

If interest rates continue to rise, which experts expect, one option is to convert your HELOC into a Fixed rate HELOC or a home loan so you can fix your interest rate and keep your payments consistent.

It is generally wise to consult a financial advisor when making important financial decisions, such as taking out a loan against your home. Financial professionals can help you understand whether such a loan makes sense for your long-term financial goals.

No matter what, it’s crucial to model different versions of your budget to make sure you can afford the monthly payments even if your financial circumstances change. Determine the maximum loan amount that you can cover if there is an interest rate increase or a life event such as job loss, so that you can continue to make uninterrupted payments no matter what macro and micro economic factors arise.

As always, monitor your credit and sign up for a free weekly credit report to make sure your credit score stays healthy as you will likely carry a balance for years with a home equity loan.

The bottom row

Home equity loans and HELOCs come with the risk of losing your house if you miss a few payments. In times of economic uncertainty and with the Federal Reserve poised to continue raising interest rates, it’s critical to make sure your monthly budget can handle fluctuations in your second mortgage payment if your payments increase. As a homeowner, you need to weigh the pros and cons of securing a loan against your property. And as with any loan, it’s always wise to shop around multiple lenders and compare rates and fees to make sure you’re getting the best deal available.